As expected, the Federal Reserve raised the target range for the federal funds rate by 25 basis points, or a quarter percent, to 5.25% to 5.50%. It was a unanimous decision. The upper bound of the range now stands at the highest level since 2001. In addition, the Fed will continue to reduce its balance sheet (quantitative tightening) by allowing up to $95 billion per month in bonds to mature without reinvestment.
At 5.5%, the upper bound of the federal funds rate is the highest since 2001
Figure 1. Chart shows federal funds rate fluctuations dating back to 1993. At 5.5%, it is the highest it has been since 2001.
Source: Bloomberg. Federal Funds Target Rate – Upper Bound (FDTR Index). Data as of 7/26/2023.
Statement was left nearly unchanged
The Federal Open Market Committee (FOMC) made few modifications to its statement, except to upgrade its description of growth to “moderate” from “modest.” However, it did retain the language that indicated job gains remain “robust” and inflation “elevated,” even though inflation has fallen substantially over the past few months.
More importantly, it dropped any allusion to pausing rate hikes in the near term, noting only that the committee will consider the cumulative tightening and the lag time between a change in policy and its effect on the economy and any new financial developments in setting policy.
Are we there yet?
The big question facing the markets is: Does this hike represent the peak in the fed funds rate for the cycle, or are there more rate hikes ahead? That question remains unanswered. After the last FOMC meeting in June, Federal Reserve Chair Jerome Powell indicated that the committee believed it was “near its destination.” Based on his comments after this meeting, the Fed doesn’t seem clear on how far away it is from reaching its goal but does believe policy is currently “restrictive,” or tight enough to slow growth and inflation. Nonetheless, Powell indicated that the Fed was prepared to be “patient and resolute” in reaching its inflation goal.
With the Fed data-dependent, we believe the key metrics to watch for signs that inflation is coming under control are economic growth and inflation. Powell repeated previous comments that the Fed is looking for a softer labor market and below-trend growth over a period of time. Notably, Gross Domestic Product (GDP) growth since the Fed signaled policy tightening has averaged 1.1%, compared with a pre-pandemic average of 2.4%. However, GDP growth recently has rebounded after a few quarters of negative growth, which may have lowered the Fed’s confidence about a further drop in inflation.
Inflation-adjusted GDP growth has been below trend
Figure 2. Chart shows real, or inflation-adjusted, GDP growth dating back to March 2013. During the period before the COVID-19 pandemic began in March 2020, real GDP growth was averaging 2.4%, but the average during the past five quarters has been 1.1%.
Source: Bureau of Economic Analysis, quarterly data as of 3/31/2023.
Gross Domestic Product (GDP CQOQ Index), GDP U.S. Chained 2012 Dollars SAAR. Pre-pandemic average date range: Q1 2013 to Q4 2019.
Note: Y-axis capped at 20% and -20% for scaling purposes. For reference purposes, the low was 29.9% 6/30/2020 and the peak was 35.5% 9/30/2020. Gross domestic product (GDP) measures the final market value of all goods and services produced within a country. It is the most frequently used indicator of economic activity. The GDP by expenditure approach measures total final expenditures (at purchasers’ prices), including exports less imports. “Real” GDP growth is adjusted for inflation.
The labor market has shown signs of cooling, with job and wage growth decelerating, but apparently not enough for the Fed to be confident that policy is restrictive enough to get to 2% inflation down the road. Most likely the Fed would like to see those wage gains in the 3% region, rather than the current pace of more than 4%.
Average hourly earnings growth remains relatively strong
Figure 3. Chart shows average hourly earnings growth dating back to June 2013. As of June 30, 2023, average hourly earnings were growing at a more than 4% annual rate, based on a 3-month moving average.
Source: Bloomberg, using monthly data as of 6/30/2023.
US Average Hourly Earnings All Employees Total Private Monthly Percentage Change (AHE MOM% Index). Y-axis capped at 10% and -1% for scaling purposes. For reference purposes, the high was 22% 4/30/2020 and the low was 8.4% 7/31/2020.Source: Charles Schwab, Bloomberg, Federal Reserve, 1929-2019. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Yields fluctuated following the statement’s release and into the press conference. The yield curve remains inverted, continuing the trend over the past year.
On to the September meeting
With an open-ended outlook from the Fed, the markets are likely to focus on the July employment report and the upcoming 2Q Employment Cost Index report (ECI), along with GDP growth as drivers of inflation until the September meeting. In the meantime, the annual Kansas City Federal Reserve meeting in Jackson Hole, Wyoming in August may provide some indications of which way the committee is leaning in setting policy.
For now, we look for the uncertainty about Fed policy to contribute to elevated volatility. Longer term, we continue to believe that peak in the rate-hiking cycle is near and that yields will decline over the long run, but there is still a bumpy road ahead.
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