FED DECLINES TO HIKE, BUT POINTS TO RATES STAYING HIGHER FOR LONGER

As anticipated, the Federal Reserve decided to maintain the current interest rates within the range of 5.25% to 5.50%, but it did signal an expectation for at least one more increase before the year's end.

The Federal Reserve's statement remained largely unchanged from July. Nevertheless, there were notable alterations in both its economic forecasts and the "dot plot."

Regarding economic projections, the Fed now anticipates a 2.1% year-on-year growth in 2023, a significant increase from its 1.00% projection in June. Additionally, it foresees the unemployment rate concluding the year at 3.8%, a revision from its June estimate of 4.1%. Concerning inflation, the PCE inflation projection rose by 10 basis points to 3.3%, primarily due to higher energy prices, while the Core PCE inflation projection decreased by 20 basis points to 3.7%.

One aspect that remained unchanged was the Fed funds rate projection, which remained steady at 5.6%, indicating the expectation of one more rate hike in 2022. Looking beyond 2023, the median projections for the federal funds rate in 2024 and 2025 were both adjusted upwards by 50 basis points.

This stands in contrast to the current expectations in the Fed fund futures market. Before the meeting, the market implied a probability of over 50% that the Fed would keep rates steady through the end of the year, with rate cuts likely beginning in June 2024.

Evidently, there is a misalignment between the market's expectations and those of the Federal Open Market Committee (FOMC). Should the Fed maintain higher rates for a longer period than anticipated, it could have a negative impact on the stock market, which is why both the stock and bond markets experienced simultaneous declines.

The driving force behind the Fed's revised outlook is the unexpected resilience of the economy and labor market. While there have been some signs of softening in the labor market over the past year, such as moderating wage gains and improved job openings-to-workers ratio, tighter financial conditions are taking longer than expected to produce the economic weakness the Fed is seeking.

Consequently, the Fed's only recourse is to keep rates elevated for an extended period until it achieves the desired effect. With inflation expected to remain well above the Fed's 2% target for at least the next year, tighter financial conditions are likely to persist. Unless an economic shock occurs that swiftly reduces inflation, Powell is careful not to provide reasons for the "doves" to relax these conditions.

U.S. Treasury yields saw an increase following this news, with the 2-year yield reaching its highest level since 2006. It remains to be seen whether this upward trend will continue in the coming days. Institutional speculators seem to be betting on it, as evidenced by historically large short positions against Treasury bonds across the yield curve, as indicated by commitment of traders (COT) data.