• Fed held rates steady at 5.25%-5.50%

• Modest changes to the policy statement

• Fed notes "strong pace" of economic activity last quarter

• Bond yields move lower after Fed rate decision

• The Fed could continue to shrink its balance sheet, even as it cuts rates

• Fed won’t rule out one more rate hike

The Federal Reserve opted to leave interest rates unchanged at the conclusion of the Federal Open Market Committee policy meeting on November 1, marking the second meeting in a row where the central bank has skipped a hike in its current policy-tightening cycle.

The call, which was widely expected, keeps the target for the federal-funds rate at 5.25%-5.50%, leaving the central bank’s benchmark lending rate at its highest level in 22 years.

In addition to announcing that interest rates will remain at a 22-year high, the Federal Reserve also said it will "continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans”. The Fed sells government securities from its multitrillion-dollar balance sheet, which are listed as assets, whenever it wants to cool down the economy to curb inflation, and vice versa whenever it wants to stimulate growth to prop up employment.

The Fed’s post-meeting statement noted that “economic activity expanded at a strong pace in the third quarter”. Despite the Fed aggressively raising interest rates 11 times since March 2022 in a bid to combat inflation, the US economy has not only avoided a recession so far, but instead expanded at a blistering 4.9% annualized rate in the third quarter, mostly due to solid consumer spending.

Modest changes to policy statement

The Federal Open Market Committee (FOMC) made modest changes to its policy statement, adjusting it to reflect a stronger labor market and more restrictive financial conditions.

The opening paragraph of the November statement now says that job gains “have moderated since earlier in the year but remain strong”. That line previously said job gains had slowed in recent months. The change implicitly acknowledges the surprising strength that has shown up in the labor market since the September meeting.

Where the Fed had previously highlighted “tighter credit conditions for households and businesses” that are likely to weigh on economic activity, it is now highlighting “tighter credit and financial conditions”.

The rest of the statement remained unchanged, including the line that the Fed will be considering several factors as it works to determine “the extent of additional policy firming that may be appropriate to return inflation to 2% over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”.

Powell not satisfied with inflation progress

At a press conference, Federal Reserve Chair Jerome Powell said that officials were not yet satisfied with the progress being made on inflation and that monetary policy might not be restrictive enough. Policy makers are also watching rising bond yields, which have also contributed to tighter financial conditions.

Federal Reserve Chair kicked off the post-policy meeting press conference by reiterating that the central bank is "squarely focused" on the dual mandate to promote maximum employment and stable prices. He said “We understand the hardship that high inflation is causing and we remain strongly committed to bringing inflation back down to our 2% goal”. While there’s been some progress on bringing down inflation, it has not reached that target yet. The pace of the personal-consumption expenditures (PCE) price index slowed to 3.4% over the 12 months ending in September. Excluding the volatile food and energy categories, core PCE prices rose 3.7%.

“Inflation has moderated since the middle of last year and readings over the summer were quite favorable. But a few months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal”. Powell said policy makers felt it was worth keeping rates steady at November's meeting because tight monetary policy is putting downward pressure on economic activity and the full effects of previous increases have not been fully felt yet and noted that “Given how far we have come along with the uncertainties and risks we face, the committee is proceeding carefully”.

Fed is watching bond yields closely. Financial conditions have tightened significantly in recent months, driven by higher longer-term bond yields. Powell said central bank officials are closely watching the situation. Powell said the FOMC was “attentive” to the increase and statant that “Persistent changes in broader financial conditions can have implications for the path of monetary policy”. Powell also noted a stronger dollar and lower equity prices are also playing a role in tighter financial conditions in the US. Powell said that it was “too early” to determine whether the rise in yields would last, and added “We just don’t know how persistent this will be”.

The economy’s surprising resilience is one reason behind the recent run-up in bond yields, with the benchmark 10-year US Treasury yield hovering near the 5% threshold — though it dipped below 4.8% following the Federal Reserve's announcement that it is holding interest rates steady for another meeting. However, what's really moved yields today has little to do with the Fed. Earlier, the Treasury Department announced its quarterly refunding plans, which involves auctioning a slightly smaller amount of debt than investors expected.

Fed won’t rule out one more rate hike

The Fed’s November policy statement left the door open for further interest-rate hikes in the future, should central bank officials decide the economy needs it. The latest policy statement preserves language that says the Fed will continue to examine how much “additional policy firming” might be needed in order to slow price growth down to the central bank’s 2% annual target.

Officials will be considering the lags with which monetary policy operates, economic and financial developments, and the cumulative impact of the actions it has taken so far as it determines whether and when to raise interest rates beyond the current level of 5.25% to 5.50%. The Fed had previously penciled in one more quarter-point rate hike this year, which could come at the December meeting. Most Fed watchers think Chair Jerome Powell will refrain from shutting the door completely on further rate hikes to preserve optionality moving forward, even once the committee is finished tightening. The committee wants the markets to know the door is still open to further hikes if necessary.

Chair Powell recognizes that the economy is starting to see the effects of tighter monetary policy, but that the committee still has a bias towards more hikes rather than seeing the prospect of cuts on the horizon. This is understandable since the Fed does not want to give the market the excuse to significantly backtrack on the recent repricing of “higher for longer” policy interest rates. While there does appear to be a slight softening in the degree of hawkishness the FOMC is expressing, they are careful not to provide a signal that policy has peaked, which could tempt traders to drive market rates lower in anticipation that the next move would be rate cuts.

Still, it is likely the Fed will keep its policy unchanged into next year but, there are risks in both directions. The rise in inflation expectations, combined with strong economic activity, preserves the prospect of another rate hike. Conversely, a more pronounced economic slowdown caused by the growing impact of higher interest rates might accelerate the timeline for transitioning to rate cuts. FOMC will meet next on December 12-13 to deliberate for the next set of policy decisions.

Source: BIMB Securities Research - 2 Nov 2023