A one-on-one conversation with Greystone’s Head of CMBS Trading, Serafino Tobia, about interest rates and The Fed’s expected moves as we approach the end of 2023.
You recently predicted that The Fed would likely pause on rate increases for the reminder of the year. What are the factors pushing toward one more increase, and the factors that could prevent another increase?
My view that the Fed would pause a further Fed Funds rate increase at the November 1 meeting (which is now confirmed) and possibly the December 12 meeting reflect public comments from Fed officials on the FOMC committee including Fed Chairman Powell. In early October, Mary Daly, the President of the Federal Reserve Bank of San Francisco, commented that, with the recent substantial increases in interest rates in the bond market, the market itself had tightened credit availability and therefore the Fed could hold off on any further Fed Funds rate increases. Daly’s view was confirmed by several Fed officials including Chairman Powell at his speech and subsequent talk with Bloomberg’s David Weston at the New York Economics Club on October 19.
The Fed Funds target range is now 5.25% - 5.50%. In an effort to slow the economy and reduce inflation back to the Fed’s target inflation of 2%, over the past year and a half, the Fed has moved the Fed Funds rate up from near 0% to the 5.25% - 5.50% range (and reduced its balance sheet holdings with Treasury and MBS securities asset sales, or Quantitative Tightening, “QT”). However, while inflation has come down significantly since the summer 2022, inflation remains sticky at 3.5%+. Fundamentally, the Fed is grappling with the question if the Fed Funds rate needs to be pushed even higher or if interest rates are high enough now and just need to be “high for longer.” The US economy has proven to be resilient; over the past year employment growth, consumer spending and production have consistently surprised to the upside. In many respects, the US economy seems to be insulated from the blunt tools that the Fed can use to slow the economy. The interest-sensitive sectors of the economy (housing/mortgages and autos and durable goods that require financing) benefited during the COVID pandemic with homeowners locking-in sub-3% mortgages. The interest-sensitive sectors have only recently started to show signs of slowing. It is my view that interest rates are sufficiently high at this point but that we will likely need rates to remain high for the Fed’s monetary policy to slow the economy and reduce inflation further.
How much have recent geopolitical events put a pause on increases?
Geopolitical events can influence Fed monetary policy to the extent the events restrict economic activity, impact commodity prices and influence bank liquidity or market liquidity. As yet, I don’t see Fed monetary policy being driven by the most recent geopolitical events; the Israel-Hamas conflict has not had a significant impact on the economy, prices and/or bank/market liquidity. There is clearly risk of further developments in the Israel-Hamas war and the possibility of a broader conflict involving Hezbollah, Iran and the United States. A wider conflict will likely cause crude oil prices to increase and, with investors moving to safer investments, Treasury yields are likely to move lower. The Fed could look to pause (or even reduce rates) if the economic, banking, and market disruption is more severe.
Based on the most recent “Fed Dot Plot,” do you expect higher rates to be sustained through 2024 and 2025 within 50-75 bps?
Yes, the Fed Dot Plot (the Fed officials survey and forecast for the level of the fed funds rate over the next few years) was substantially revised at the September FOMC meeting. The Dot Plot, at that time, indicated that the Fed intended to raise the Fed Funds rate another ¼ point before the end of the year and then move the Fed Funds lower by a half point in 2024 and by another half point in 2025. The Fed Dot Plot had previously indicated a 1% cut in the Fed Funds rate in both 2024 and 2025. Keep in mind that the Dot Plot is a survey of the Fed officials at a point in time and has (and will) change with changes in economic activity and inflation expectations. Clearly, however, the current Dot Plot signals “higher for longer” Fed Funds rates.
Is reaching 2% inflation possible?
2% inflation; well, that’s the open question and difficult to answer with confidence. However, I believe – yes – but to reduce inflation further, it will likely require the economy and consumer demand to slow. It’s clear that the Fed is intent on keeping monetary policy sufficiently restrictive to achieve the 2% inflation target. To my thinking, Fed Chairman Powell is in the process of writing his legacy. For the right reasons or not, the Fed’s (i.e., Powell’s) “easy money” policy during the pandemic (near-zero interest rates for too long and massive asset purchases, or Quantitative Easing, “QE”) contributed substantially to inflation over the past two years. Recall top-line CPI inflation reached 9.1% in the summer of 2022. Powell is now fully intent to reverse the inflation effects of his zero-rate/easy money policy and will keep financial conditions restrictive to achieve it. The caveat – the Fed’s monetary policy is a blunt tool and impacts primarily the interest rate sensitive portion of the economy – housing and durable goods requiring financing. As we know, inflation is also driven by fiscal policy (deficit spending) as well as commodity prices globally (driven by supply and demand and geopolitical events). Energy prices and grain price inflation has been driven in part by the war in Ukraine; crude oil prices are also higher reflecting OPEC+ production limits.