As the highly anticipated FOMC meeting on July 26th approaches, the consensus among traders, analysts, and markets is that there's a 99.8% chance of a 25-basis point increase in the Fed funds rate, bringing it up to 5.5%. This would mark a 5.25% increase in just 16 months, the sharpest rate hike in 43 years. However, upon closer examination of the Federal Reserve's dual mandate, which is to achieve full employment and price stability, one might question the need for further aggressive rate hikes, as it seems the goals have already been achieved.
Starting with the employment aspect, the Fed's target rate of unemployment is subject to differing opinions among economists. Nevertheless, for the purpose of this analysis, let's use the benchmark of 5.5% as the target. The current unemployment rate is well below this mark, standing at 3.6%, the lowest since 1969, a remarkable 54-year low. Despite Chairman Powell's cautious statements about unemployment at the Jackson Hole Symposium in August, where he predicted some challenges, the job market has remained resilient. Thus, it appears that the goal of achieving full employment has been met and is under control.
Regarding price stability, the Fed focuses on inflation and deflation, and the injection of trillions of dollars into the markets over the past three years naturally led to a surge in inflation. In June 2020, the Consumer Price Index (CPI) measured 0.1%, but by July 2022, it had soared to 9.1%, becoming a prominent topic in media discussions. However, since the rate hikes initiated in March 2022, inflation has significantly decreased to 3.0%, much closer to the Fed's target of 2%. With inflation on a rapid decline, the need for further rate hikes is questionable. Moreover, it takes time for rate increases to fully impact the economy, and the last five rate hikes may not have fully taken effect yet, potentially bringing inflation closer to the Fed's target.
Considering Gross Domestic Product (GDP), the current rate of 2% is stable and not far from historical averages witnessed before the Covid pandemic, which is not a cause for concern.
In summary, when all the relevant factors are analyzed, the economic situation appears favorable. Inflation is declining rapidly, unemployment is at historic lows, and GDP is stable. Despite the market's anticipation of a rate hike, there is a compelling case for the Fed to surprise and pause for the second time. The dot plot in the Fed's Summary of Economic Projections suggests rates may reach 5.6% by year-end, but given the faster-than-expected decline in inflation, raising rates again could stress the economy, particularly the financial sector, impacted by an inverted yield curve.
A prudent approach would be to pause again, waiting for further data to warrant another hike. Allowing the markets to take a breather and observing potential changes in the longer end of the yield curve could reduce systemic risks for banks. While this may be a long shot, it presents a scenario where Wednesday afternoon could turn into a bullish day to remember.