Allegory of the summer barbecue: Analysis on the stance of Fed policy and the likely path forward

Executive summary:

• The FOMC raised interest rates by 25 bps today as expected, after skipping a hike at the June meeting.
• The Fed continued to signal a "meeting-by-meeting" data-dependent approach to monetary policy. While the June Summary of Economic Projections suggested that there might be one more hike after today's, we think it's also possible that today's hike may be the last one.
• We don't expect the Fed to start cutting rates until the labor market softens. If a recession materializes, we anticipate that the Fed would cut rates quite aggressively, perhaps even taking rates down to the zero lower bound. 

The bottom line: We continue to expect a mild-to-moderate recession over a 12-18 month horizon. We believe it's prudent for investors to be disciplined, and we think that U.S. Treasuries can be an important defensive tool in portfolios.

Summer is here. Beaches are packed and the weather is hot. And the smell of charcoal fills the air as people flock to parks for summer barbecues. But getting the perfect piece of grilled chicken or steak is a daunting task. The U.S. Federal Reserve (Fed) faces a similarly herculean endeavor as it tries to bring inflation back down to its target.

Meat hasn't reached necessary internal temperature: Why the Fed raised rates after a June skip

After a piece of meat has been on the grill for a while, you might momentarily turn off the grill as you check the temperature with a meat thermometer. But as you poke the thermometer into the meat, you realize that it hasn't reached the required internal temperature to be fully cooked.

The Fed has made some noteworthy progress in its attempt to bring inflation back down to target. On a non-seasonally adjusted basis, core consumer price index (core CPI) inflation rates have fallen from a peak of around 6.6% year-over-year in 2022 to 4.8% year-over-year in June 2023. Core personal consumption expenditure (core PCE) inflation, the measure the Fed likes focusing on, has fallen from a recent peak of 5.4% year-over-year in early 2022 to 4.6% in May 2023, on a seasonally adjusted basis.

But core CPI and core PCE rates are still above the Fed's 2% inflation target. And with the unemployment rate continuing to remain near historic lows, and economic growth expanding at a 2.0% seasonally adjusted annualized rate in the first quarter of 2023, the Fed likely believed it needed to take additional action to ensure inflation rates would reach the desired level. Thus, the Federal Reserve decided to raise interest rates by 25 basis points (bps) today, even though it had skipped a hike in June. The meat was not fully cooked, so the Fed had to continue grilling.

Market reaction was relatively muted, with the S&P 500 ending the day roughly flat. Given that markets had placed a 99% probability on a 25-bps hike going into this meeting, the lack of a strong market response was understandable. 

The Fed doesn't have the benefit of USDA guidelines: Why the terminal rate can still be uncertain

There's a key difference between our barbecue protagonist and the Fed: The Fed doesn't have the benefit of USDA guidelines. While the Fed has access to a variety of econometric models, none of these can definitively say how high interest rates have to be in order to bring inflation back to target within a reasonable timeframe.

At the June press conference, members of the FOMC had indicated that the U.S. could see two rate hikes in the second half of 2023. With today's rate hike out of the way, those projections would suggest we might see one additional hike by the end of the year.

But of course, the Fed is not required to stick to the projections. Chair Powell continued to signal that the Fed would adopt a “meeting-by-meeting” approach to monetary policy decision making. That means it's possible that today's hike could be the final one in this cycle. We've written extensively about how leading economic indicators were pointing to signs of a slowdown ahead, even as some of the more lagged measures still exhibited resilience. Now, even some of the more lagged measures are pointing to slowing. Monthly job creation in the U.S. has slowed from a pace of nearly 500,000 jobs in January 2023 to just over 200,000 jobs in June 2023. And based on data from Refinitiv Eikon as of today, economists expect that job creation in July will slow down even more, to around only 184,000 jobs.

By the time of the Fed's next meeting in September, the central bank will have received two more payroll reports and two more PCE reports. It's possible that inflation and economic growth might cool sufficiently to obviate the need for additional rate hikes this cycle.

The flip side of the data-dependence coin: if the data were to remain unexpectedly hot, the Fed may deliver its next hike as early as the September meeting. Indeed, Chair Powell noted that the Fed will not constrain itself to only hiking at every other meeting.

Burned chicken is better than raw chicken: How the Fed's risk management calculus plays into monetary policy-setting decisions

When you put a piece of chicken on the grill, you have a delicate balancing act: overcook it, and it looks unappetizing and leaves a bad taste in your mouth. But if you undercook it, you risk eating raw chicken, which could result in a trip to the hospital. While you might not be able to achieve perfection, you'd rather risk burning the chicken a bit than winding up sick.

The Federal Reserve has been engaged in a similar balancing act. On the one hand, the Fed doesn't want to overtighten and inadvertently tip the economy into a recession. On the other hand, if monetary policy is set too loose, the central bank could lose its inflation battle. However, faced with two undesirable situations, the Fed would likely opt for bringing inflation under control, even if it means the economy falls into a recession. Chair Powell noted today that any short-term costs associated with controlling inflation would be dwarfed by the long-term costs of not managing inflation.  

This risk management calculus means that interest rates are likely to stay in restrictive territory for some time, until the Fed has seen clear and convincing signs of the labor market softening and inflation rates getting even closer to target levels. As of today, markets are expecting that interest rates will remain above 5% through year end. If the economy continues to be resilient and inflation remains sticky, then the Fed will likely need to keep interest rates at elevated levels.

Meat continues to cook on the plate: How the Fed may have already overtightened

Even after you remove the steak from the grill, the steak can continue to cook on the plate. The magnitude of this effect can vary, making the barbecuing process difficult to manage. If you underestimate how much the steak cooks on the plate, you might find that the steak is no longer optimal when you go to eat it.

Likewise, we remain concerned that the Fed may have underestimated the full impact of interest rate hikes, leading to a potential overtightening situation. As mentioned in our 2023 Q2 Global Market Outlook, monetary policy acts with long and variable lags. This means that it's hard to gauge what the full impact of the rate hikes will be.

Much of the Fed's focus has been on lagging data rather than forecasts. This is understandable given the Fed's forecasts have been wrong on how persistent inflationary pressures would be. But waiting for the lagging indicators to fully turn means that you risk underestimating the full impact of the rate hikes, and could end up raising interest rates more than is necessary—thereby overtightening the economy into a recession.

It's true that the recent strength in some of the economic data has caused some analysts to lower their estimate of recession risk. And Chair Powell noted that the Fed staff now no longer expect a recession as their base case. But from our perspective, we think that it's too early to get excited about the Fed pulling off a soft landing. History is not on the Fed's side.

With interest rates already well above our estimate of the neutral rate of interest—the level of interest rates that neither stimulates nor dampens economic growth—we continue to see an elevated risk of recession. As indicated in our recently published 2023 Q3 Global Market Outlook, we think that a recession in 2024 is likely, and a recession in late 2023 can't be fully ruled out either.

Bring an umbrella but don't cancel the barbecue altogether: How we believe investors should position themselves amid recession risk

When you barbecue, paying attention to the weather forecast can be important. If a period of rain is possible, you might want to bring umbrellas to protect yourself, or make sure the park you are barbecuing at has a picnic shelter that you can hide under.

Similarly, we continue to believe that U.S. Treasuries can be a useful defensive tool in your investment toolkit. Although the days of zero interest rates may seem like they are long gone, we believe that markets are not fully pricing in how aggressively the Fed would respond in a recession scenario. Our analysis suggests that if a recession does materialize, we could find ourselves back at zero interest rate policy.

Against that backdrop, U.S. Treasury yields would likely fall, and since Treasury yields are inversely correlated to price, investors would likely profit from holding Treasuries.

Equity valuations, meanwhile, appear stretched at current levels. While there has been a lot of enthusiasm around artificial intelligence (AI), we would caution investors from getting overly excited. Our composite contrarian indicator—a measure of how optimistic or pessimistic other investors are—is getting close to the euphoria threshold.  When other investors are overly excited, we think it might be beneficial to exercise restraint.

We do not believe that equities have fully priced in recession risk, and if the recession does materialize, we would not be surprised to see a significant equity market drawdown. But timing recessions is incredibly difficult, and although we believe a recession to be the most likely outcome, we do not yet believe it's inevitable. The Fed could still defy the odds and pull off a soft landing. If recession is avoided, the tailwind from AI excitement may continue for a bit longer. All this to say, we don’t think investors need to cancel the barbecue outright—they can continue to hold equity allocation close to their strategic levels, while perhaps skewing the equity portfolio slightly defensive towards quality stocks.