The outcome of the September FOMC was a bit more hawkish than our expectations. Nevertheless, the main message was loud and clear and it was what we expected: “for longer”. There were no major surprises in the forecast, while the dots were a bit more hawkish than expected. We review our calls as per our “Pre-FOMC Meeting Package”. The conclusion is always the same: in this market, it is incredibly hard to be a bull, especially the long-end, unless you expect a recession.
For brevity, we proceed by bullet points.
- No major surprises in the SEP. In our “Pre-FOMC Meeting Package” we wrote: “As for the SEP, we expect the new projections to signal lower core inflation in 2023 (to 3.5%-3.6%) but a stronger economy (higher GDP growth and a touch lower unemployment rate)”. Overall, there were no major surprises. The only difference is that the FOMC expects a pretty strong economy in 2024 with the unemployment rate remaining around 4 percent.
Figure 1. The September 2023 SEP.
- For longer means for longer. The main difference between our “Pre-FOMC Meeting Package” and the SEP is that the path of the FF rate is higher than expected. In our email we wrote “in this environment it does make sense to take a pause (no hike) but remain hawkish with the optionality of an extra hike in 2023, just in case. At some point, it will become clear whether the Fed has done enough. Until then, it makes sense to take a pause but remain in the “for longer” highland”. The message is the same (steepener) but, for the first time in the last 2 years, the FOMC managed to be more hawkish than us!
- FRB-US wins everything (again). In retrospective, the FRB-US forecast for the FF rate turned out to be great (the reader can refer to this note or to Figure 2 below). This is not the first time the unconstrained FRB-US forecast turns out to be very accurate, as it happened also with the June SEP (see here). Indeed, once again FRB-US correctly signaled upside risks for the FF rate in 2024 and 2025, with the level in 2024 almost identical to the new SEP. (Note: in FRB-US, U* is at 4.5%, while in the SEP is at 4%. This -together with the different projected growth- explains why the two forecasts converge to a different level at the end of the medium-term).
Figure 2. Latest FRB-US forecast (orange line) vs June SEP (blue line)
Note: Real GDP growth and core inflation are expressed as YoY. Core inflation is core PCE price inflation. The blue line shows the latest SEP. The orange line shows the “inconsistent FRB-US” forecast (the current baseline), that is the model-based forecast removing the “add-factors” put by the Fed staff to match the latest SEP.
- Higher r* coming? In the new SEP, the median longer-run federal fund rate remained at 2.5 percent but the distribution shifted higher (from 2.5-2.8 to 2.5-3.3, in yellow in Figure 1). At this point, it would not be surprising if in the coming rounds the median would also tick higher.
- The core PCE price inflation issue is still there. The main issue is still the same: conditional on no recession, it is very hard for the Fed to project core PCE price inflation to 2 percent (the reader wants to disregard the “2026” column in the SEP in this moment as, by definition, the real-side variables converge back to their steady-state levels – if anything the small puzzle is why the FF rate in 2026 remains above its long-run level despite all other variables at their long-run levels).
Where do we go from here?
There is (only?) one clear way down for long-term rates: a recession. As we wrote since June, it makes sense in this environment to stop being aggressive with the front-end of the curve (“bet against the hawkish Fed”), unless the central bank put a zero weight on the labor market. In this environment, (i) we cannot rule out to remain above target in the medium-term, and (ii) a central bank obtains more by steepening the curve. Translated: everything screams “high for longer” or if the reader prefers “long-end of the curve under stress”. (Note: while we draft this e-mail, the 10y Italian yield is trading at 4.55%, the highest level of the last 6 months. We are not surprised. As we are not surprised to see the 10y Treasury at 4.45%. Cheers!). What can go wrong? At this point, the suspect is that only a recession can significantly lower the curve.