Update 731 — Fed Again Pauses Rates: No News is Good News or Hawkish Hold?

The Federal Reserve once again held interest rates in place, maintaining a 5.35-5.50 percent prime rate target, driving slowly like a car with dimmed headlights in a fog rather than stopping and preparing for an imminent reversal of hikes. Its critical December meeting could be the occasion for another, possibly final, rate hike on the Fed’s long road to reach its two percent inflation target, but that depends on a number of macroeconomic and even fiscal factors which we detail below.  

The resilience of the economy evidenced by the 4.9 percent 3Q23 GDP growth rate and 3.8 percent unemployment presents a challenge to the traditional view of the trade-off between Fed rates and economic performance, as Chicago Fed President Austan Goolsbee and others have pointed out. Perhaps for this reason, the consensus view now is that another FOMC hike raising rates by 25 basis points at its December 12-13 meeting is itself only a 25 percent probability and that a soft landing remains achievable.  



The Fed Hits Pause Once Again

The Federal Reserve has opted once again to hold interest rates steady at the 5.25 – 5.5 percent range. The Federal Open Market Committee (FOMC) announced the broadly expected pause following the conclusion of its October/November meeting this afternoon. The question now is whether interest rates have reached their peak for this cycle of rate hikes, or whether another 25 basis point hike is in the cards for the FOMC’s upcoming meetings this and next year. The immediate market reaction, one percent gains in equities indices and a sharp drop in bond yields, suggests an optimistic view that the Fed is done raising rates on the part of investors. 

The Fed is likely nearing the end of its most aggressive series of rate hikes since the 1980s, having raised the federal funds rate from near zero in early 2022 to a twenty-two-year high in its effort to cool inflation. Inflation has fallen significantly and continues to steadily trend down but remains above the Fed’s target of two percent. Meanwhile, the economy remains stubbornly resilient.  

These factors may push the Fed toward another hike in December or early 2024 before interest rates peak. The Fed’s statement following this week’s meeting gave few signs of any changes in the FOMC’s expectations for its subsequent decisions on interest rates. But Federal Reserve Chair Jerome Powell stressed during his press conference this afternoon that the work of interest rates in bringing down inflation is ongoing, market optimism notwithstanding. 

Indeed, at this stage in its cycle of rate hikes, the central bank is undoubtedly cautious of overtightening. The impact of recent rate hikes continues to ripple throughout the broader economy and will likely continue to unfold as the Fed has indicated its intention to hold rates higher for longer. The FOMC will meet next to decide the fate of interest rates on December 12 and 13. 

Shockingly Strong Growth in the Third Quarter

Economic data continues to show a remarkably resilient economy despite the Fed’s tightening of monetary policy. The United States economy grew by a shocking 4.9 percent over the third quarter of 2023 according to the advance estimate provided by the Bureau of Economic Analysis last week  — up from an increase of 2.1 percent during the second quarter of the year — the steepest quarterly increase since the fourth quarter of 2021. 

Gross domestic product (GDP) growth during July, August, and September was primarily driven by increases in consumer spending and inventory investment. The strong labor market has continued to support increased consumer spending on both goods and services. Increased spending on services derived mainly from cash outlays for housing and utilities, health care, financial services and insurance, and food services and accommodations. The rise in spending on goods was particularly strong in spending on nondurable goods, mainly prescription drugs, and spending on recreational goods — including on vacations and concerts— and vehicles. Increased inventory investment flowed primarily from a rise in manufacturing and retail trade. Imports, which contribute to a decrease in the figure, rose over the quarter.

Such strong GDP growth is unlikely to continue in the fourth quarter of this year and into 2024 since consumer spending during subsequent quarters will likely take a hit with the resumption of student loan repayment and the rise in yields on long-term U.S. treasuries. The Fed — which would like to see below-trend growth to be assured that inflation is trending towards its two percent target — will factor that expectation into its upcoming decision, alongside its consideration of extremely strong growth in Q3.

Financial Tightening Beneath the Surface

Despite strong economic data, higher yields on long-term U.S. treasuries suggest that, beneath the surface, financial conditions are tightening. 

The market priced yields on the array of Treasury securities that make up the yield curve serve as a benchmark for interest rates on mortgages, auto loans, student debt, and other types of loans, and these have risen significantly over the past few weeks. Yields on the 10-year U.S. Treasury note briefly reached five percent last week after crossing the five percent threshold during the prior week for the first time since 2007. 

Market Yield on U.S. Treasury 10-Year Securities

Source: U.S. Department of the Treasury
Data as of October 31, 2023

Several factors are contributing to the rise in yields on 10-year treasuries in the period from mid-2020 to present. Inflation and strong growth have likely pushed yields higher, along with the expectation that the Fed will hold rates higher over an extended period of time. 

With the increase in Treasury market yields, financial conditions have likely tightened enough to help complete the work that the Fed seeks to achieve with its monetary policy.

Potential for a Soft Landing Remains

With the strong economic data signaling resilience in the midst of tightening conditions, the potential for a soft landing remains. But as Powell stated during his press conference, the Fed believes that “three months of good data are only the beginning” and stressed that the Fed seeks to see persistent changes. 

As the Fed contemplates the end of its cycle of interest rate hikes, it is sure to pay close attention to upcoming data on inflation and the labor market. Over the next two weeks, consumer price index (CPI) data for October will be released, followed by personal consumption expenditures (PCE) price index data for October at the end of the month. The Fed will be watching closely to see if measures of core inflation continue their downward trend. 

On Friday, the Department of Labor will release the October jobs report. After September’s report showed that a far-higher-than-expected 336,000 jobs were added to the economy over the month, the Fed will be monitoring whether the trend of high job growth continues. The Fed will also be watching unemployment levels, which have remained low. Fed officials likely see the moderation in wages as a sign of progress. Wage growth has drifted towards three percent, consistent with two percent inflation and moderate productivity growth. 

At the same time, the Fed must be cautious of the ripple effects of its monetary policy, which could take months to be reflected in broader economic performance. That said, the possibility of avoiding a recession remains. Notably, Powell said this afternoon that the Fed did not place a recession projection into the baseline forecast in the materials for today’s meeting. 

The fact that the Fed’s monetary policy has not yet produced a significant disruption to the economy’s recovery — the apparent paradox that Goolsbee noted — provides an undeniable basis for cautious optimism that the steep and swift rate hikes will not certainly result in a recession.