Fed Pause Could Be Fleeting as Rate Forecasts RiseFedPauseCouldBeFleetingasRateForecastsRise

The Federal Reserve held interest rates steady on Wednesday, coming on the heels of softer inflation figures for May. Yet the central bank, which delivered rate hikes at 10 consecutive meetings prior to this week, hinted that further hikes are on the table, as it weighs the stubborn nature of inflation against budding signs of economic stress. The Fed framed the decision to pause its aggressive rate-hike campaign as an opportunity for policymakers to assess the effectiveness of previous rate moves and the broader economic impacts of tougher borrowing conditions. Inflation has pulled away from the four-decade highs of last year, giving the Fed room to slow its pace of tightening. A decline in energy costs helped the consumer price index to a 4% increase year-over-year in May, its lowest point since March 2021. Wholesale price pressures also eased, portending future relief for consumer inflation. In contrast to the Fed, the European Central Bank lifted rates by a quarter-point on Thursday in its own effort to wrangle sticky inflation, even with the region entering a technical recession.

Despite inflation’s retreat in the US, the Fed’s fight may not be over. Inflation continues to run above the Fed’s 2% target, and Chair Jay Powell said officials see inflation risks tilted to the upside. Policymakers estimated that the fed funds rate will reach 5.6% by the end of 2023, implying 50 basis points of additional increases. In a new post on The Bond Blog, PGIM Fixed Income notes that while risk management considerations tied to banking stress and tighter credit likely motivated the “hawkish skip,” the Fed’s projected rate path may fuel one of the very risks it is trying to prevent. However, a slowing pace of rate hikes may continue to support credit spreads as long-term Treasury yields drift higher.