Investment Strategy Brief:
Rate Hikes on the Horizon?

Below is a transcript of this week’s video.

Hi, this is Jason Pride, Chief of Investment Strategy and Research at Glenmede.

Investors are eagerly awaiting the Federal Reserve’s September policy meeting this Wednesday. This comes a week after the release of the August Consumer Price Index, which showed hints of a reacceleration in inflation, suggesting that the road back to the Fed’s inflation target is unlikely to be smooth.

Market expectations, as measured by the pricing of fed funds futures contracts, are currently implying a near-100% probability for a second pause in rate hikes at the upcoming meeting but leave on the table an essential coin-flip over whether one more rate hike will happen before the end of the year.

This week’s meeting will garner extra attention, as committee members are set to release their Summary of Economic Projections, which they only share once a quarter. The most notable projection will be the committee’s updated dot-plot for the appropriate level of the Fed funds rate by year-end and beyond. While the Fed has been hiking rates in 2023, this survey will likely again show expectations for some rate cuts in 2024 but, importantly, not enough to get rates back to their longer-term target. We believe this longer-term target reflects the committee’s estimate of neutral, or “R-star” in economist speak. A focus of much recent debate, R* is the theoretical neutral interest rate, the level of short-term interest rates that is neither economically stimulative nor restrictive. In short, a fed funds rate higher than this level is likely to cause a recession, due to its impact on the cost of financing, budgets, and opportunity costs for investments. Of course, such estimates are just that – estimates – with a range of uncertainty that can even be seen here in variation in the FOMC members dots on the right.

Much of the discussion at the Fed’s Jackson Hole Economic Policy Symposium in August centered around this elusive R*. There are a multitude of measures, from simple to complex, each backed by their own equations and economic theories. While not a published model, the level of nominal GDP growth over the last year provides a good first estimate that has seemed predictive in the past. Rates above such a level imply that the average business investment may not break even over the cost of financing, thus disincentivizing investment and further economic growth. Current rates have recently surpassed this measure, which is unlikely to be good sign for the economy.

A more fine-tuned estimate, like the one provided by the Holston-Laubach-Williams model, looks ahead rather than backward, creating a stronger picture of neutral and the magnitude of tightening.  This measure more clearly shows that this Fed rate hike cycle has resulted in a level of interest rates that is materially restrictive to the economy.

Of course, the point we are trying to make is that either measure points to monetary policy now being sufficiently tight to cause investors concern.

Having said this, monetary policy impacts the economy with a notable lag, historically taking 1 year to cause market weakness and 2 years to impact the economy in these three recessionary examples. It is not unusual for the economy to appear fine right before a recession. In fact, real GDP growth two quarters before the 2008 and 1990 recessions was 2.6% and 4.4% respectively, not unlike today.  

Zooming back in on that Holston-Laubach-Williams model, with rate hikes starting over a year ago but rates only surpassing neutral at the end of 2022, applying a lag similar to history would suggested that their full impact on the economy may still lie ahead. 

So to summarize: 

- Headline and core inflation have been moderating, but remain above the Federal Reserve’s 2% target
- The Federal Reserve is likely to pause again at its September session, but one more rate hike remains on the table for year-end
- The FOMC survey is likely to still point to rate cuts in 2024 while keeping rates above their estimate of neutral (R*) that disincentives growth
- The debate around the precise level of R* is unlikely to subside, but various approaches suggest that monetary policy is now sufficiently tight
- Tight monetary policy acts with a lag, suggesting that despite recent growth, the economy is likely still at risk of feeling its full impact