The US Federal Reserve (Fed) kept the key federal funds rate unchanged on 20 September, but retained an unexpectedly hawkish bias. The Fed’s guidance triggered a sharp sell-off in US government bonds. Yields on long-term Treasuries rose to their highest levels in more than a decade, putting the stock market under pressure.
While the peak for interest rates may be near, there are no signs yet of US monetary policy shifting towards easing. A slew of conflicting near-term risks affecting growth, inflation and the policy outlook is leading the main central banks to remain cautious.
A busy week for monetary policymakers
The week of 18 September saw numerous central bank meetings. Some policymakers raised policy rates while others held rates unchanged but with a hawkish tone.
The US Federal Reserve, the Bank of England, and the Bank of Japan all left their key rates on hold, as expected. However, the Fed’s latest revised economic forecasts (see Exhibit 2 below) show a resilient economy. GDP growth is expected to remain close to trend and no cyclical rise in the unemployment rate is projected through 2025. The core personal consumption expenditures (PCE) inflation forecast was revised only slightly higher for 2025, to 2.3% from 2.2% earlier.
Given this backdrop, the Fed is contemplating raising rates further in the coming months before cutting twice in 2024. However, Fed Chairman Powell’s comment that the Federal Open Market Committee (FOMC) would proceed ‘carefully’ suggested that a rate rise is far from certain.
In Norway and Sweden, the Norges Bank and Riksbank raised interest rates by 25bp and retained a tightening bias, endorsing a ‘higher for longer’ strategy.
A common factor in central banks’ caution is the impact of the labour market on the inflation outlook. So far, unemployment rates have not risen enough to weigh on wages and slow inflation. On the contrary, jobs are still being created, albeit at a slower pace. Unit labour cost growth is still high at over 4.0% year-on-year (YoY), especially in Europe and the UK (see Exhibit 3). This is not compatible with the central banks’ 2% core inflation target.
Near-term risks
The risk of a US government shutdown on 1 October has also pushed up US Treasury yields. Moody’s, the last of the big three rating agencies to give the US a AAA rating with a stable outlook, warned that a shutdown would be credit negative. One of the other major rating agencies, Fitch Ratings, downgraded the US’s credit rating this summer on concerns about a potential government default in the context of debt ceiling drama.
The US government’s legal authority on its fiscal spending, including much of its operational outlays, will expire on 30 September. If the debt ceiling is not extended, the government will have to shut down. The longer a shutdown lasts, the bigger the impact on the economy and, potentially, on the US’ credit rating. In turn, the bigger the impact on US growth and the country’s credit worthiness, the more likely that US assets, including the dollar, will suffer, at least in the short-term.
This risk is heightened market concerns because
- The House of Representatives’ Republican majority is finding it hard to reach a consensus on how and where fiscal spending should be allocated, and
- Any decision reached would likely differ significantly from the bipartisan Senate consensus.
An extended lockdown could put pressure on markets to price in a lower US growth trajectory and add to the uncertainty about the Fed’s monetary policy path at a time of sticky inflationary pressures.
Coincidentally, the three-year federal student loan moratorium will also end on 1 October and its extension was barred by the House’s debt ceiling bill. Resuming loan payments will add to the financial burden of consumers whose confidence has been falling since July (see Exhibit 4); the Conference Board consumer confidence index dropped by 5.7 points to 103 in September.
Given what has frequently happened in the past, there is a broad assumption that the government shutdown will be avoided at the eleventh hour. However, the shutdown risk reminds investors of the confluence of growth headwinds. Together with the impact of tight monetary policy on growth, this underscores our current preference for bonds over equities.
Another risk is the impact of the United Auto Workers (UAW) strike, which has now spread to 38 locations across 20 states at General Motors and Stellantis plants. The strike has renewed focus on the wage bargaining process and thus on US inflationary pressures.
If the strike is prolonged or more workers become involved, it could be bad news for inflation. Car inventories are much leaner than they were in past strikes, so a prolonged walk-out would put upward pressure on car prices. These had eased recently, helping to slow inflation and boosting market expectations of an impending interest rate peak.
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