The Fed Minutes tell us that even though the Fed may reduce the size of the individual rate hikes to 50 basis points, there will be even more rate hikes, lifting the Red Funds rate to an even higher final level.
In the first week of November, we had the meetings of both the Reserve Bank of Australia and the US and the Federal Reserve. The most important of those we think was the meeting by the Federal Reserve.
The Fed changed its view about where it was going. Jay Powell, the Chair of the Fed, said that if the Summary of Economic Projections had been prepared at that meeting, it would have shown a higher interest rate target than the one that was released in September. The reason for that is we have had a rise in core US inflation. The July number was 5.9%. This rose to 6.3% in August and 6.6% in September. This eased to 6.3% in October. We note that the median CPI at 7% is still the highest this year. We think US inflation will fall but not yet. In determining our view of where interest rates are going, we first look at the Summary of Economic Projections which are updated by the Open Market Committee members of the Federal Reserve, plus the Fed Presidents four times a year.
The next one will be updated at the meeting in mid-December. Until the comments by Jay Powell earlier this month, we thought that the Fed funds rate would peak at 485 basis points in the meeting in February next year. We thought there would be upside to where rates would go, and we thought that following that the RBA would gradually track up to around that level in the middle of next year.
We think when the Fed next meets on the 13th and 14th of December, the Fed will hike another 50 basis points to 435 basis points or 4.35%.
In February, we think the Fed will put up rates by 50 basis points to 4.85%. We think that will be followed by the next meetings on the 21st and 22nd March, where the Fed will come to an end of its period of rate rises and increase rates by 50 basis points to 535 basis points or 5.35%.
We think the RBA is following the Fed. It is following the Fed at a slower rate of 25 basis points every month. It will take all the way until August for the RBA to reach the level the Fed will have achieved by the end of March.
We think by that time it will be apparent that inflation has already begun to fall in the US and begun to fall in Australia. We think it is entirely plausible that rates in Australia don't get to the levels of the Fed, but we'll be able to talk more about that next year. So, when the Fed gets to a peak of 535 basis points next March, which we think will be the peak for the year, what is the strategy from then on?
Well, the Fed strategy has been provided to us several times in comments by Mary Daly. Mary Daly is the President of the San Francisco Fed, and she is very closely followed by central bankers around the world. Her view is that the Fed will "raise and hold." The Fed Funds rate goes up to its peak level and just stays there. The reason that staying there is it is waiting for inflation to begin to decline. When inflation falls, it continues to stay there. It stays there until such time as core inflation gets down towards the target of around 2.5% core CPI inflation rate or 2% for the PCE deflator. So, you spend a long time at that level where the rates are at their peak level of 535 basis points. Still, what we would expect would be happening at that point as inflation falls and continues to fall, is what would be seen in the bond market.
Ten-year bond yields would decline and continue to decline. That is important for equity markets. When we look at the statistical relationship between the Fed funds rate and the US equities markets, there is a very, very little statistical relationship. Still, when we look at the statistical relationship between the US and the ten-year bond yield, there is a huge statistical relationship. We think that what will happen next year is that even though the Fed Funds rate is stationary, what will happen is that as inflation falls, bond yields go down and the equities market will bottom and begin to recover.
Like I said, the RBA will follow up the Fed Funds rate next year. We think that inflation will fall in Australia at the same time it falls in the US and we will not have to get to whatever peak the Fed has. Still, we will know a lot more about the perspective of interest rates after the next meeting of the Federal Reserve, which is on the 13th of December.
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