The Federal Reserve just announced its interest rate policy decision and decided to keep the federal funds rate at 5.25 to 5.50%. While market watchers tend to key in on the Fed’s rate decision, another important announcement was being made in the form of new quarterly economic projections that investors can use as a forecast for policy. Today’s projections show that the Fed is prepared to raise rates further and keep them there longer, if necessary, to stabilize prices.
While the Fed held its targeted interest rate for 2023, that rate is an additional 25 basis point higher than the current fed funds rate. Additionally, the Fed has increased its 2024 fed funds target from 4.6 to 5.1% to signal that rates will stay above 5% for another 15 months (they’ve been above 5% for just over 4 months). The committee also raised its 2025 target by 50 basis points and introduced its 2026 Federal funds target at 2.9%, 40 basis points above the targeted rate. The message is simple: we’ve been above the long term fed funds target rate of 2.5% for a year and we will not return there for 3 more years!
The Fed’s economic growth projections also signify its commitment to stay vigilant. While GDP growth projections for 2023 shot up to over 2%, the Fed’s 2024 economic growth target remains below its long-term target rate of 1.8%. With an estimated growth rate of 1.5% in 2024, the Fed does not appear likely to pivot if economic growth (or various reports that feed into economic growth) comes in soft.
Like growth, the unemployment rate has continued to outperform the Fed’s expectations in 2023, leading them to lower their current year estimates to the current rate of 3.8%. While 2024 and 2025 unemployment projections have also been lowered, they remain above the committee’s long-term target of 4%. The Fed is communicating to the markets that it will tolerate slightly higher than targeted unemployment if it means bringing prices under control.
What is the most fascinating portion of the Fed’s economic estimates is their inflation projections. The Fed has held its headline inflation estimate for 2024 at 2.5% for four consecutive quarters while also projecting that core PCE inflation will drop from its current 4.2% level to 3.7% by the end of the year. The Fed has disinflation ramping up in 2024 with a projected drop in core inflation to 2.6%. I believe these projections are ambitious and may require a 6% federal funds rate to achieve it, as a strong labor market and strong consumption continues to show pricing trends above the Fed’s 2024 projections. At a minimum, these inflation targets likely signal no rate cuts in 2024.
What should be reassuring to investors is that the market seems to be accurately pricing in the Federal Reserve’s policymaking projections. December 2024 Fed fund futures are currently priced 35 basis points under the Fed’s 2024 projections after rising by 25 basis points over the last five trading days. This is a smaller variance than what we saw earlier this year. Interestingly, the market currently anticipates rates to moderate at a much slower rate than the Fed projects, with 2025 fed fund futures trading 75 basis points above projections and the full Fed funds curve is projecting rates above 4% through 2027!
The Treasury markets are also beginning to accept the reality of higher rates for a longer time. Since the last Federal Reserve meeting, long term Treasury rates have jumped noticeably higher, especially when comparing between the June and July meetings. It’s safe to say that at 5.5% on a one-year Treasury bill, buyers of one year Treasuries are not expecting a cut until at least the fourth quarter of 2024.
While the market and the Fed are more aligned on rate outlook, concerns still remain. First, equity markets are still overvalued with earnings yield well below the risk-free rate. At some point, higher interest rates will impact earnings and without significant earnings growth, current market valuations simply cannot hold. Secondly, I have significant concerns regarding the flows of Treasury debt in a high rate environment (a thesis I further detail here). These concerns become further exacerbated by a longer than expected high-rate cycle, but there’s no other option to bring price stability to our economy, therefore we must continue on the current course.