The Fed holds steady, but signals one more hike

The U.S. Federal Reserve kept interest rates unchanged at the September policy meeting, as expected. The committee left open the possibility of one more hike later this year.

What happened?

The U.S. Federal Reserve left interest rates unchanged at 5.25% - 5.50%, a 22-year high. The policy statement contained minimal changes to key wording, and Chair Jerome Powell continued to signal reasonably high odds of another rate hike later this year.

The policy statement continued to characterize inflation as “elevated” and upgraded the language about growth to “solid” from “moderate.” The policy outlook language remained unchanged, discussing “additional policy firming that may be appropriate.”

The updated summary of economic projections showed a large upward revision to 2023 real GDP growth, from 1.0% to 2.1%. The core inflation forecast was revised down slightly, from 3.9% to 3.7%. The dot plot of rate expectations continues to show one more rate hike this year, as expected, while the 2024 dots moved higher to reflect only 50 basis points of rate cuts next year.

In his press conference, Chair Powell emphasized that the Fed remains committed to decreasing inflation to the 2% target. He said that the FOMC can afford to “proceed carefully” and will take upcoming decisions on a “meeting-by-meeting” basis. This likely signals a strong possibility, but not a certainty, of one more rate hike.

Recent data have been supportive

The data released during the intermeeting period broadly supported the Fed’s prior economic projections. Core CPI inflation has moved down to +4.3% year-over-year, a -1.4 percentage point deceleration so far in 2023. On the other hand, core services excluding housing, a key measure for the Fed, re-accelerated to its fastest pace in almost a year.

The labor market remains bulletproof, adding around 150,000 jobs on average over the last three months. At the same time, the participation rate has moved higher, with prime-age employment reaching a 22-year high. Nevertheless, cracks are emerging, as the quits rate is now below the 2019 level and the number of job openings continues to fall.

The economic outlook remains healthy, with growth slowing but not collapsing. This is what the Fed wants, and it should be sufficient for inflation to decline through the end of the year. We continue to forecast a material growth slowdown over the coming quarters, with a year-end core inflation rate near 4%.

What does this mean for investors?

With the Fed inching closer to the end of its rate hikes and the economic backdrop remaining uncertain, volatility will likely pick up again. We continue to believe Treasury yields should moderate over the course of this year and expect the curve to become less inverted.

For investors looking to increase yield without moving into full risk-on mode, we think it makes sense to explore areas of the broad bond market, including municipals. One way to do this is by adding to investment grade corporate bonds, which have relatively longer durations than the broader fixed income market. They are also currently yielding close to 6%, and defaults are expected to remain low. We also favor selectively taking on risk in other credit sectors like senior loans, emerging markets debt and preferred securities, although duration in these categories is lower than in corporate bonds. 

While investors may find ways to play offense and defense in the U.S. equity market, the S&P 500 Index is currently trading at an approximately 6% premium to its 10-year average on a forward price-to-earnings basis. These rich valuations help inform our neutral stance on U.S. equities overall. But allocating more broadly via a globally diversified equity portfolio provides attractive opportunities in certain pockets of both developed and emerging markets.

In private capital markets, we prefer allocating to income-producing asset classes with the potential for returns less correlated to the broader market. In particular, we see compelling opportunities in select areas of private credit and private real estate.