What higher-for-longer Fed policy will mean for the markets and economy


From the perspective of the markets, this week’s Federal Reserve Meeting wasn’t about its intentions for September. Or the rest of 2023. Even 2024 is not out of the question. The central bank’s real message, which has rattled the markets, was that it intends to raise rates again this year and cut them a few more times next year. But the rate trajectory over the long term will be higher than the one investors have been forced to accept for the past two decades. Nicholas Colas wrote in a blog post Wednesday, following the Federal Open Market Committee’s meeting, that “Seeing these numbers black and white clearly rattled capital markets.” Colas stated that Fed Chairman Jerome Powell’s most important task was to reset market expectations regarding real rates. Powell spoke with the media after the end of the two-day meeting. Markets are concerned about rates because they directly affect the cost of financing. Money has been extremely cheap since the financial crisis of 2008-09. Wall Street has prospered. Low rates have been used by companies to fund growth, purchase stock and keep liquidity flowing during an expansionary period. The Fed’s officials said at their meeting this week that they expect rates to remain higher for longer. The policymakers think they have to increase the cost of money to slow down inflation-inducing economic growth. They may also be doing it because they feel that they can. According to updated economic projections, Fed officials are expecting unemployment to remain low and inflation will slowly drop back to their target of 2% with minimal disruption to economic growth. “Radical Shift” The second position is a “radical change to a baseline of a soft landing,” according to Krishna Guha, Evercore ISI’s head of global strategy and central bank policy. Summary of Economic Projection showed that unemployment would rise from the current level of 3.8% to 4,1% in two years. This skirts the “Sahm Rule”, named after Fed economist Claudia Sahm. It states that the economy enters recession when the unemployment rate rises 0.5 percentage points from its cycle low. FOMC officials doubled their expectations for GDP growth in this year as they announced the jobless rate outlook. This indicates that they are able to hold rates high without causing recession. From a market perspective, Guha thinks the “higher-for-much-longer rate path” will be good for cyclical stocks and the U.S. dollar, but present problems for the broader stock market and especially the technology stocks that have played such a big part in the 2023 rally. Guha wrote in a client note that he would be concerned if the Fed stuck rigidly to their new, high-for much-longer-period priors. Powell and Co. will, we believe, become more pragmatic with time. Doubts regarding hikes The reliance that the Fed will not stick to a strategy and be data-dependent is what fuels some of the more dovish talks on Wall Street. Wall Street’s commentary on Wednesday and Thursday was largely centered around Powell’s press conference where he stated that he adhered to real rates or the difference between inflation and the fed funds benchmark rate. There is a belief that the Fed will not need to maintain high nominal rates if inflation falls, because real rates are expected to rise. Morgan Stanley, as an example, remained firm in its belief that the Fed has finished raising rates for this cycle, and will begin cutting rates as early as March 2024, with three additional reductions following. The Fed and the markets have both become overly dependent on growth. This has led to two problems. (1) Is this growth scenario sustainable and will the growth continue to surprise on the upside? No, we think. What happens if inflation pressures are not present, and growth continues to grow as it has done so far? Ellen Zentner is the chief U.S. economics at Morgan Stanley. Markets are vulnerable to growth surprises that do not last. In their projections dot plot, the policymakers indicated that they only see 50 basis points or two quarter percentage points cuts by 2024. This is down from the four reductions that were indicated in the June update. Goldman Sachs economists believe that a less aggressive cut is better for the economy. They are not expecting a rate decrease until the fourth quarter next year. There is a belief that the Fed would prefer to keep rates higher if inflation falls and growth continues. This is a scenario they believe is likely. If FOMC participants continue to move toward our view of no cuts, they may conclude that rate cuts next year are not worth it if the economy continues to grow and the labor markets remain tight. This is what Goldman economist David Mericle wrote in a recent note. Goldman also doesn’t expect any further hikes. Mericle says that even though the dot plot indicated a final hike this year, it is more likely a way to allow the Fed flexibility in case the data does not support its goals. The market will be kept guessing by the uncertainty over the Fed’s direction. DataTrek’s Colas stated that central bank officials will likely resist cutting rates until they see evidence of the “long and variable effect” of the rate increases on the economy or if another type of “exogenous” shock occurs. Colas stated that the Fed will not be able to control inflation until either of these two things occur. This tells us the current equity market turmoil is unlikely to stop until bond markets settle down. “