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Federal Reserve Set to Meet as Rate Cut Expectations Fade and Inflation Debate Continues

The U.S. Federal Reserve (Fed) Will Meet Again Next July 29, Against a Market Backdrop Where, According to Experts from International Investment Firms, the Reasons for an Interest Rate Cut Seem to be Vanishing. Specifically, They Highlight That June’s CPI and PPI Reports Surprised to the Downside, Which Reduced the Risk of an Imminent Rate Hike by the Fed and Caused Yields on Two-Year Treasury Bonds to Fall.

“June Inflation Data Represented a Double Favorable Blow to the Market. Headline CPI Fell 0.4% Month-on-Month, Reducing the Annual Rate from 4.2% to 3.5%, While the Core CPI Remained Unchanged for the Month and Moderated to 2.6% Year-on-Year. Today’s PPI Report Reinforced This Message by Falling 0.3% Against Expectations of a Flat Reading, with Core Measures Also Weaker Than Expected. Energy Was a Key Factor in Both Releases, but the Moderation in Core Consumer Prices and Core Producer Price Indicators Suggests the Improvement Was Not Exclusively Due to Oil,” Explains Afonso Borges, Fixed Income Analyst at Julius Baer.

Furthermore, Experts Point Out That New York Fed President John Williams’ View That Monetary Policy Is Well Positioned and That Inflation Has Likely Peaked Reinforces the Case for Keeping Rates Unchanged. However, Markets Still Anticipate Potential Monetary Tightening Later This Year, with a Possible Resolution in the Strait of Hormuz Offering an Additional Disinflationary Catalyst. All of This Leaves the Scenario Open to Debate.

Latest Inflation Data

In the View of Martin Hochstein, Senior Economist at Allianz Global Investors, Persistent Inflation, Shifting Fed Forecasts, and the Approach Likely to be Taken by Kevin Warsh Point Toward a New Cycle of Monetary Tightening. “Our Baseline Scenario Regarding the Resilience of the Global Economy Remains Unchanged. Nevertheless, Inflation Continues to Sit Above Target Levels in Most Major Economies. Additionally, a Spike in Market Volatility Could Test Our Central Scenario of an Economy That Bends but Does Not Break,” He Explains.

In This Context, the Asset Manager Has Revised Its Forecasts for U.S. Interest Rates, Considering That the Risk Profile Has Shifted: Whereas It Previously Pointed Toward Further Rate Cuts, It Now Supports the Possibility of a New Cycle of Monetary Tightening. They Now Expect the Federal Reserve to Raise Its Policy Rate by a Total of 50 Basis Points During the Second Half of the Year.

“Until Now, We Expected Kevin Warsh, the New Fed Chair, to Take a More Gradual Approach Before Initiating Rate Hikes. Initially, Our Base Case Contemplates Rate Increases in September and December. However, We Do Not Rule Out the Fed Front-Loading Part of the Tightening Cycle, Though We See Hikes at the July and September Meetings as Unlikely. The Three Factors Explaining This Shift in Our Assessment Are Persistent Inflation Showing No Signs of Abating; Inflation Outlooks from the Fed That Contrast with Its Monetary Policy Stance; and Markets Misinterpreting the Leadership Change at the Fed,” Argues Hochstein.

Inflationary Factors

Geopolitics Remains One Element Watched Closely by International Asset Management Experts. “Macroeconomic and Geopolitical Risks Continue to Weigh on Market Sentiment on the Doorstep of Earnings Season. Tensions in the Middle East Remain Unresolved. However, Markets Appear Less Sensitive to Events Surrounding the Strait of Hormuz Than They Were at the Start of the Year,” Acknowledges Louise Dudley, Global Equity Portfolio Manager at Federated Hermes.

According to Sebastian Paris Horvitz, Head of Research at LBP AM (Majority Shareholder of LFDE), “The Situation in the Strait of Hormuz Has Worsened,” Warning That “The Closure of the Strait of Hormuz Threatens the Rebound in Economic Activity.” He Also Notes That Reduced Tanker Traffic Has Driven Oil and Gas Prices Up Again, Warning That “A Prolonged Closure of the Strait of Hormuz Would Translate into Much Higher Energy Costs.”

Against This Backdrop, He Notes That “An Adverse Scenario Must Be Considered Once Again,” Explaining That Heightened Risks Will Drag Down Confidence and Economic Growth. “Events in the Middle East Undermine the Idea of a Quick Exit from the Crisis and Make Recent Macroeconomic Data Harder to Interpret. In Fact, Business Surveys Were Beginning to Show Signs of Economic Recovery Right when Hostilities Resumed. In the U.S., June Inflation Figures Were Quite Reassuring, but the Deceleration Trend Could Be Threatened Unless Energy Markets Ease. Headline Year-on-Year Inflation Fell to 3.5%, Down from 4.2% in May,” Horvitz Acknowledges.

The Fed’s Pulse

For Tiffany Wilding, Economist at PIMCO, Recent Statements by Fed Officials Suggest That “Policymakers Are Increasingly Preparing Markets for the Possibility of Renewed Monetary Tightening If Inflation Does Not Moderated as Expected.”

“In a Broader Sense, Fed Communications Have Shifted Recently to Emphasize the Importance of Keeping Inflation Expectations Firmly Anchored in the Face of Supply Shocks. In His Testimony Before Congress, Fed Chair Kevin Warsh Reiterated the Central Bank’s Firm Commitment to Restoring Price Stability and Maintained That, Despite a Softer June Inflation Report, the Fed’s Inflation Target Has Not Yet Been Reached,” the Expert Recalls.

Nonetheless, the PIMCO Economist Maintains That “We Still Expect Inflation to Moderate During the Second Half of the Year and for the Fed to Keep Rates Unchanged.” In This Regard, She Reminds That “This Is Not 2022,” as “Labor Markets Are No Longer Generating the Same Degree of Inflationary Pressures, Fiscal Policy Is Far Less Expansionary, and—Crucially for Fixed-Income Investors—Real Yields Are Already Substantially Higher.”

From Julius Baer, Borges Maintains That the Fed’s Decision-Making Structure Will Continue to Limit Kevin Warsh’s Ability to Substantially Alter Monetary Policy. “The Committee Reaffirmed Its Commitment to an Ample-Reserves Framework, While Guidelines from Waller and Williams This Week Demonstrate That the Fed’s Priorities Remain Intact. Given Limited Support Within the Committee for a Drastic Reduction in Transparency or a Structurally Smaller Balance Sheet, We Expect a Warsh-Led Fed to Represent an Evolution from Powell’s Era, Rather Than a Revolution,” He Adds.