- Next Fed policy statement comes on 23 March
- Markets now expect Fed Funds rate to peak at 5.5%
- But Federal interest bill is soaring to suggest there is a limit to how far the Fed can go
“Sticky inflation, especially in services, a tight labour market and a renewed surge in stock market speculation all mean the US Federal Reserve may be more reluctant to pause its run of interest rate increases and then pivot to cutting rates than investors had hoped as we entered 2023,” says AJ Bell investment director Russ Mould. “However, there may be a limit to how far the Fed can go. America’s government is nudging up against its $31 trillion debt ceiling and while the inevitable horse-trading and pork-barrel politics on Capitol Hill mean that is likely to be increased, the federal interest bill is surging as rates rise – it already represents 23% of federal tax receipts and can only go higher if both the debt ceiling and Fed Funds rate go up.
Source: FRED – St. Louis Federal Reserve database
“The good news is that 23% is not a historically high percentage of tax income, and the latter looks buoyant thanks to a bouncy stock market generating lots of capital gains tax and a strong economy.
“The bad is that tax receipts could plunge if the either the economy or stock market slides (or both). This is what happened during 2000-03 and 2007-09 and the US could ill afford that, especially if the Fed is still jacking up interest rates as it grapples with inflation that it is running at levels last seen in the early 1980s.
Source: FRED – St. Louis Federal Reserve database
“This is the dilemma that potentially faces Fed chair Jay Powell and the other members of the Federal Open Markets Committee when they next set policy on 23 March.
“If they put the hammer down on inflation, and thus interest rates, the US Government’s ability to spend could be severely constrained, and that would hurt, especially in the event of a recession, when welfare programmes and federal spending could be required to provide support.
“The Government could just plough on spending regardless, especially if this scenario comes to pass before the November 2024 Presidential Election and the current incumbent in the White House, Joe Biden, feels a need to curry favour with the electorate by providing further financial or economic support. Yet that would leave the US needing to find someone to buy more US Treasuries to cover any increase in spending (or decrease in revenue) and the logical candidate would be the Fed – except that potentially means more Quantitative Easing, when the central bank is currently trying to shrink its balance sheet at the same time it is raising interest rates.
“This is a similar-looking trap to the one from which the Bank of Japan is trying to extricate itself, and why the current battle between the bond and currency markets and the Japanese monetary authority is so crucial, especially as the BoJ has a new governor about to take over, in the form of Kazuo Ueda.
“For the moment, however, markets are backtracking on their view that the Fed would be able to pause rate hikes at around the 5% mark and then start cutting by year end.
“The central bank’s preferred measure of inflation, the Personal Consumption Expenditures index, is not retreating as fast as the headline Consumer Price Index benchmark, while the services element of the CPI index is showing little sign of cooling.
Source: FRED – St. Louis Federal Reserve database
“In addition, the labour market remains strong, with unemployment at just 3.4%, its lowest mark since 1968. Wage growth of 4.4% is well above the Fed’s overall 2% inflation target.
Source: FRED – St. Louis Federal Reserve database, US Bureau of Labor Statistics
“What’s more, stock markets have rallied hard, especially some of the more speculative areas such as meme and tech stocks. That in turn seems to have supported US consumer confidence and spending. Official benchmarks suggest there is little sign of financial distress or policy tightness in the US, despite the fastest-ever tightening of policy by the Fed (albeit from the loosest starting point ever).
Source: Chicago Federal Reserve, FRED - St. Louis Federal Reserve database
“This all helps to explain why markets now expect Mr Powell and the FOMC to take the Fed Funds rate to 5.00% from 4.75% at its meeting on 23 March and then push through further hikes to 5.50% by summer, a level at which investors now believe the Fed funds rate will end the year, according to the CME Fedwatch service.
Source: CME Fedwatch
“That in turn informs the surge in the US two-year Treasury yield to more than 4.75%, a level last seen in 2007. The two-year traditionally leads, or anticipates, Fed policy, by some six to nine months.
Source: Refinitiv data, US Federal Reserve
“But, again, the harder the Fed pushes, the greater the stakes for the economy. When he was Fed chair, Paul Volcker could take US rates to the high teens in the early 1980s because the US Federal debt was then barely $1 trillion, not $31 trillion (and rising). Even then, Mr Volcker’s harsh monetary medicine saw the Federal interest bill almost double. Such an increase this time could be difficult to sustain indeed, at least without a return to lower rates and QE, but that then could leave inflation inadequately attended.”
