Not So Fast

The last Federal Reserve tightening cycle resembled a road trip along a scenic route. From 2015-18, it stopped along the way to gauge the economy. This time around has felt like a race, with only glances at the passing landscape. It has been more about the speed than the journey.

Despite another large 75 basis-point hike in the fed funds target range, now at 3.75-4%, the Fed signaled today it might be appropriate to downshift before long. The Federal Open Market Committee (FOMC) is mindful of the cumulative tightening that has taken place and the lags inherent in their policy actions. How fast might not be as critical as arriving at the right place and not leaving too soon.

New language to this effect was included in the official statement to the meeting, and it inevitably was misinterpreted as dovish until Fed Chair Jerome Powell beat that impression back in his press conference. He emphasized that inflationary pressures and economic conditions since September’s FOMC meeting would indicate an even higher target rate peak than previously forecast by committee members might be needed. While he said that the pace of hikes was not as important as the peak, he sternly added it would be very premature to interpret this as being a step closer to a pause. There clearly is much road left to travel.

By the conclusion of the press conference the futures contracts reflected probability of a peak fed funds rate of just above 5% sometime in the second quarter of 2023. That is in line with where they started the day and largely consistent with our own views at Federated Hermes. The door is open for a smaller hike at the next FOMC meeting in December, but there is a lot of data to be released between now and then.

Meanwhile, the process of quantitative tightening (QT) continues. Powell emphasized during the press conference today that the Fed intends to continue with plans to significantly reduce the size of its balance sheet. The Fed will continue to allow $95 billion per month of securities to roll off its balance sheet, $60 billion of Treasuries and $35 billion in agency MBS. QT should eventually lead to incrementally higher short term interest rates and a reduction in both bank reserves and the Fed’s Reverse Repo Facility (RRP). The Fed kept the metrics to the RRP unchanged today, raising the RRP rate by a full 0.75% to 3.80% and keeping the counterparty limit unchanged at $160 billion. To date, however, the RRP has remained stubbornly above $2 trillion and is not expected to change materially in the near-term. As a result, bank reserves will likely continue to decline, with the Fed watchful not to let them fall too far.