The Fed's Critical Transition

No longer raising, set to cut...

The FED RATE remained unchanged as a result of the FOMC meeting last week. But what's the future look like? asks Jim Rickards in The Daily Reckoning.



Today, I'll explain what happened in terms of policy moves, what Fed Chair Jay Powell believes will happen next and what will actually happen.



The difference between Powell's expectations and market expectations creates opportunities for investors to profit from those competing forecasts.



Whether we see the Dow plummet over the next few months, or a weakening economy with a recession imminent, you've got a front-row seat to research, strategies and recommendations that can help you weather the storm and profit.



Last week the Fed kept the fed funds rate unchanged. At the same time, they leaned in a more dovish direction with regard to their next policy move, while warning that rate hikes are still on the table in certain circumstances.



It's important to look at the Fed's reasoning behind its moves and to consider what's next both for the Fed and the US economy.



Fed Chair Jay Powell's press conference following the announcement is always more informative than the official announcement and this meeting was no exception. Powell's insistence on flexibility going forward is obvious.



As has been the case since last summer, Powell is caught on the horns of a dilemma. On the one hand, inflation remains too high.



On the other hand, if Powell raises rates or simply holds them too high for too long, the inflation could turn to rapid disinflation or even deflation accompanied by a recession.



Powell understands the dilemma, but he does not know which way to turn. His solution is to do nothing and wait for more data.



That said, the meeting was highly significant in the sense that the FOMC statement and Powell's remarks were dovish. The Fed turned from a possible rate hike to a possible rate cut as their next move. Nothing was set in stone and no clues were given as to timing, but the tilt toward easing instead of more tightening was unmistakable.



Of course, Powell tried to have it both ways. He said, "Inflation has eased from its highs...without a significant increase in unemployment." In the next breath he said, "Inflation is still too high." The way to reconcile these statements is to understand that while inflation may be too high, interest rates may be high enough to combat the inflation without further rate hikes.



That's the definition of the "terminal rate" and that's where Jay Powell believes the Fed is right now.



Specifically, Powell said rates are, "likely at or near the peak rate for this cycle," and "the full effects of our tightening likely have not yet been felt." That's another way of saying we're at the terminal rate.



As if to hammer the point home, Powell said, a rate hike "is not the base case anymore as it was 60, 90 days ago."



Powell left a few markers that rate hikes might still be needed if the economy does not play out as expected. He said, "We still have a ways to go. No one is declaring victory. That would be premature." He added that wages are running higher than what would be consistent with the policy goal.



That's a sign that demand-driven inflation could be on the horizon in place of supply-side inflation, which is waning. To keep his options open, Powell went on to say, "We will need to see further evidence...that inflation is moving down sustainably toward our goal," and, "We are prepared to tighten policy further if appropriate."



One of Powell's more intriguing comments was that the Fed would cut rates before inflation hits the 2.0% target. The idea is that if inflation falls from 3.2% to, say, 2.5%, the Fed might cut rates at that stage.



The view is that with inflation falling quickly, it could overshoot the 2.0% target and end up at 1.0% or lower. That's a reason to cut rates when inflation is still 2.5% and then watch inflation glide smoothly to the 2.0% target.



All of this gives the Fed too much credit for finesse. They're not as nimble as this analysis makes them sound. But the remarks do give insight into their thinking, which will help with forecasting in the future.



Powell also wrestled with an arcane point raised by a reporter. If inflation falls faster than nominal rates, that means real rates are going up. The real rate is simply the nominal rate minus inflation.



If nominal rates are stuck at 5.5% and inflation drops from 3.2% to 2.5%, then the real rate went up from 2.3% to 3.0%. That's a different form of tightening but one which could cause the Fed to cut rates quickly if inflation falls quickly.



Powell also reminded reporters that "We're not talking about altering the pace of QT right now." QT is quantitative tightening, another form of monetary tightening. So even without interest rate hikes, the Fed is still running a tight money policy.



Powell took a nod in the direction of a recession when he said, "Maybe people bought so much stuff that they temporarily don't want any more stuff." That's a reference to a recent slowdown in consumer spending.



Markets loved the dovish tilt despite the nuance about real rates and recession. Stock indexes rose about 1.4% to new all-time highs. Gold rallied 2.5% to $2045 per ounce. The yield on the 10-year Treasury note plunged from 4.2% to 3.9%, producing huge capital gains in Treasury notes.



Even oil futures rose to $74.50 per barrel up from $69.00 earlier in the day. We'll see how long the optimism lasts, especially in the face of recessionary signs. For now, markets want to party like it's 1999.



On the whole, last week's meeting was important considering that the Fed didn't actually do anything.



The tilt away from hawkishness toward dovishness was critical. It triggered rallies in stocks, bonds and gold – what some traders call an "everything rally".



The next Fed meeting is Jan. 30-31, 2024. A lot will happen between now and then including more data on inflation, unemployment and economic growth that will affect the Fed's decision-making process.



I'll be watching all of it carefully and bringing you the latest analysis as events unfold.