CIO sees greater upside for fixed income relative to equities, which are already priced for a benign economic outcome. (ddp)

Ahead of the meeting, markets were pricing a more than 50% chance that the July hike would be the central bank’s last of this cycle. Such optimism has contributed to the rise in equity markets in recent weeks, which had taken the S&P 500 as much as 19%higher so far this year, and within around 5% of the all-time high reached at the start of 2022.

Our expectation is that Wednesday's hike will indeed turn out to be the last of this cycle. As Fed Chair Jerome Powell noted, slowing inflation reflects normalization following the pandemic as well as the Fed's restrictive monetary policy. These factors should help to keep inflation down in the near term, giving the Fed little reason to hike rates in consecutive meetings.

But the outcome of the July meeting underlined our view that investors cannot yet take the end of the cycle for granted and that risks remain.

The Fed remained eager to stress its inflation-fighting credentials. Inflation data for June came in below expectations; the core measure that excludes food and energy rose 4.8% annually, versus a consensus estimate of 5% and down from the peak of 6.6% in September. Despite this encouraging news, Powell stressed that one good reading was insufficient to claim victory in the effort to tame inflation. He added that core inflation was still elevated, and the Fed needed to “stay on task” until it was brought back down to the 2% target. While he said that monetary policy was restrictive, in that it was putting downward pressure on economic activity, it could be necessary to hold rates at restrictive levels for some time or raise them further to get inflation back to the Fed’s goal.

The Fed will also remain alert for warning signs that expectations for higher inflation are becoming entrenched. The median inflation expectation among consumers for five years from now rose by 0.3 percentage points in June to 3%, the highest reading since March 2022, based on the latest New York Fed survey.

Powell refused to rule out a further rate hike, as implied by the most recent dot plot, which charts the predictions of top policymakers. Powell said rates had come a long way since the Fed started hiking in March 2022, with 525bps of tightening. The lagged effect of these rate rises, the fastest since the 1980s, meant the Fed could afford to be “patient” as well as “resolute.” He added that it was “certainly possible” for rates to rise at the Fed’s next policy gathering in September, or that they would be held steady. Powell acknowledged that as monetary policy had become more restrictive, the choice of whether to hike at subsequent meetings became “finely judged decisions.”

Incoming data could still disappoint ahead of the Fed’s next meeting on 19–20 September. The unusually long eight-week gap between meetings means there will be two more consumer price index readings and two more monthly employment updates in the meantime. While we expect further signs of cooling inflation and jobs growth, risks remain that the data will surprise in a way that could encourage Fed officials to follow through with an extra 25bps increase. Powell emphasized that the Fed would make its decision at the September meeting on the basis of the full range of incoming data.

So, while recent signals have been pointing to a positive combination of slowing inflation and a resilient US economy, risks remain. Against this backdrop, we see greater upside for fixed income relative to equities, which are already priced for a benign economic outcome. The rise in yields in recent months provides a good opportunity for investors to put excess cash to work. The more defensive, higher-quality segments of fixed income look most appealing to us, given the all-in yields on offer and the potential for capital appreciation as investors shift their focus from inflation risks to growth risks.

Main contributors - Solita Marcelli, Mark Haefele, Christopher Swann, Brian Rose, Vincent Heaney

Original report - Fed leaves open the possibility of further tightening, 27 July 2023.