Although the Fed's decision to hold the Federal Funds rate steady on Wednesday was widely anticipated, all eyes were on the Fed's future rate projections for the months—and years—to come.
In their summary of economic projections, the majority of Federal Open Market Committee (FOMC) members signaled that they believe that there will be only one rate cut this year, a drop from the three cuts projected in March. Meanwhile, the FOMC increased the number of rate cuts they're projecting for 2025 and 2026, to a total of two percentage points of cuts by the end of 2026.
However, the bigger news coming out of the Fed's projections was the committee's change to its long-run target rate—that is, the Federal Funds rate after the year 2026, assuming the U.S. is at full employment and inflation is at 2%, said BOK Financial® Chief Investment Officer Brian Henderson. Now the FOMC believes that this rate will be 2.8%, compared to a projected rate of 2.5% only six months ago.
"With this change, the Fed realizes that there are structural issues in the economy that necessitates a higher longer-term neutral funds rate—and it may go even higher," Henderson said.
One issue is the job market. "The labor market doesn't have the supply of workers it had in the past," he said, explaining that it's partly due to the number of Baby Boomers who have been retiring.
Another issue is federal deficit spending, Henderson continued. "The government has been running high spending deficits, which boosts economic growth, requiring a higher neutral funds rate."
Together, the tight labor market and high federal deficit spending have helped contribute to lingering inflation, which the Fed has been fighting with a "higher-for-longer" rate strategy. The May Consumer Price Index report (CPI), which was released the same day as the FOMC announcement, showed that inflation overall remained steady month-over-month but was still up 3.3% year-over-year. Meanwhile, "core CPI," which excludes food and energy prices because of their volatility, was up 3.4% year-over-year.
"The Fed realizes that there are structural issues in the economy that necessitates a higher longer-term neutral funds rate—and it may go even higher."- Brian Henderson, chief investment officer, BOK Financial
Economy hasn't reacted to high rates as expected
As this latest data shows, inflation has remained over the Fed's 2% target despite the Federal Funds rate being at its current level for nearly a year. Normally, high interest rates, lead to a slowdown in economic growth, which in turn works to bring down inflation due to reduced demand for goods and services.
Yet despite the Fed's efforts to quell inflation with this method, financial conditions have remained supportive of economic growth.
"The S&P 500 hit a new high on June 12 and credit spreads remain tight. This is all indicative of pretty easy financial conditions."- Brian Henderson, chief investment officer, BOK Financial
In other words, the U.S. economy hasn't been behaving in response to high rates as it theoretically should because of the structural issues that Henderson mentioned. As a result, it has been more difficult for the Fed to lower inflation to its 2% target. The FOMC itself noted this during their May meeting, when committee members discussed that high rates seem to be having less of an impact now than they have had in the past.
What's softening the blow of high rates
In addition to those structural economic issues, some parts of the economy haven't even felt the full impact of the previous rate hikes, Henderson said.
"Wall Street has repriced, but Main Street—the real economy—hasn't felt the full brunt of higher rates."- Brian Henderson, chief investment officer, BOK Financial
For example, the majority of homeowners aren't feeling the impact of high mortgage rates because they bought their home or refinanced with a fixed-rate mortgage when rates were low, he explained. Nationwide, 88.5% of U.S. homeowners with mortgages have an interest rate below 6%, a January 2024 Redfin study found. By comparison, the current rate for a 30-year, fixed rate mortgage was 7.914%, as of June 10.
This volume of homeowners with mortgages below the current rate has created a "lock-in effect" in which many homeowners have decided to stay in place to avoid having to buy a house and take on a new mortgage at a higher rate, the Redfin study noted.
Similarly, corporations that issued their debt when rates were low also aren't feeling the impact of high rates on this debt, Henderson said. Instead, they may actually be benefitting from the current environment if they have high cash balances earning interest, he added.
However, the longer the Fed keeps rates high, the more corporate debt will come due, which is part of the reasoning behind the Fed's higher-for-longer strategy to bring down inflation, as opposed to increasing rates further, Henderson said.
"I don't think a rate hike is completely out of the question and would never say never, but inflation hasn't been accelerating; it's stalled. And so, I think the Fed would prefer to just hold rates up where they are for longer and let more corporate bonds come due," he explained.
"If the Fed starts signaling a rate hike, there's the risk that the market will start pricing in more than one, which the Fed doesn't want."
. © 2024 BOKF, NA.