Investment Strategy Brief:
Skip but No Pivot

Below is a transcript of this week’s video.

 Hi, this is Ilona Vovk with Investment Strategy at Glenmede.

The May inflation report that was released last week unfolded largely as expected, with headline and core CPI respectively posting monthly gains of 0.1% and 0.4%. A 3.6% month-over-month decline in energy prices was a significant contributor to the headline figure’s softer print. The headline and core inflation numbers on a year over-year basis, now sit at 4.0% and 5.3% gains, respectively. Now both seem to have peaked and have moderated over the last few months.

This inflation report appeared to confirm that inflation is moving in the right direction, though not clearly enough to call a definitive end to the inflation concern. The FOMC likely saw enough progress to warrant a skip in its rate hike campaign, we saw last week.

With that said, the market-implied probability of a 0.25% July rate hike remains the base case, if looking at the fed funds futures contracts, currently there is a 77% likelihood of a hike next month.

Last week, the FOMC also released their second quarterly dot plot for 2023, which shows each participant’s outlook on the appropriate level of short-term interest rates in the future. In a relatively unexpected development, the median year-end fed funds target rate increased to 5.5 – 5.75%, suggesting that two more rate hikes are on the table this year. Now that is a considerable shift from the median expectations from FOMC members last quarter which had the median target rate at 5 – 5.25%. Additionally, the dot plot shows that the Fed plans to hold rates well above neutral through 2024.

Considering all of this, where does this leave the state of monetary policy this year? Well as mentioned before, the fed funds rate remains meaningfully above the neutral level, suggesting that the state of policy is tight and will likely remain tight. However, there appears to be disagreement as to the finer points of where monetary policy heads from here to the end of the year. The majority of Fed officials continue to echo the intentions expressed in the FOMC’s June’s rate projections, which calls for peak fed funds just over 5.6%. On the other hand, the fed funds futures market suggests that investors are betting against such a path. Instead, they are pricing in that rates will remain basically unchanged for the remainder of the year.

The result of more than a year of aggressive rate hikes has led to considerably tight monetary policy. A skip by the Fed may seem favorable, but the magnitude of tightening is more important, as this tightening cycle has been one of the swiftest hiking campaigns in history. Investors must remain cautious in this environment, as past periods of significantly tight monetary policy have not been favorable to the economy, often preceding recessions with a lag. Why the lag? It often takes time for monetary policy to permeate into the economy, often in the form of higher borrowing rates and reduced demand.

So to summarize, while moderating, the pace of inflation continues to exceed the Fed’s preferred 2% target and warrants the continuance of tight monetary policy; Although the FOMC chose to skip raising rates at its meeting last week, another rate hike remains the base case for the July meeting; The median respondent in the new dot plot projection now expects two more rate hikes this year, in contrast to prior market expectations for cuts; Generally, the debate over skip, pause or pivot will likely continue, but the fed funds rate is expected to remain well above neutral through 2024; Past periods of similarly tight monetary policy have not been favorable to the economy, often preceding recessions with a lag.

And with that, thank you for listening! And please don’t hesitate to reach out with any questions.

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