The Fed: A Hike Born of Strength

The Federal Reserve’s latest rate hike reflects an economy that remains resilient even as inflation stays above target. We look at what the Fed’s shift toward tighter policy could mean for rates, inflation and investors.

The same economic strength that powered corporate earnings this year, combined with inflation that remains above target, prompted the Federal Reserve to act. In September, the Fed raised its policy rate by a quarter point to a range of 3.75%–4.00%. Chair Warsh cited a stronger labor market and economic activity, summer inflation readings that “weren’t passing the test,” and the effect of geopolitics on commodity prices. He described the move as “removing a dose of accommodation,” which we read as a central bank concluding the economy can handle somewhat tighter policy, rather than an emergency response to runaway inflation. The Fed was not alone, as most major central banks have also resumed raising rates.

The Fed’s message was firm as 16 of 18 policymakers projected at least one additional increase this year. Officials also lifted their expected rate path for each year under forecast, while moving the estimate of the long-run “neutral” rate up from 3.1% to 3.25% – a sign that policymakers expect rates to stay somewhat higher over time than they did just a few months ago.

Data released since the Fed’s mid-September decision has been more encouraging. Core PCE inflation, the Fed’s preferred measure, rose a softer-than-expected 0.25% in August and 3.0% over the past year. Methodology revisions also lowered prior readings, so core inflation now looks likely to finish the year below the Fed’s own 3.4% projection. New York Fed President Williams said there is “no need for urgency,” and several forecasters have pushed back their next expected hike, seeing a real chance that no further increases are needed.

Still, inflation has remained stubborn. Higher energy prices have kept costs elevated, and AI-related demand is outrunning the supply of power, equipment, and construction capacity. Demand is also proving harder to cool than usual, as fiscal support and strategic AI investment make parts of the economy less sensitive to higher interest rates, while the US consumer continues to demonstrate resilience. This increases the possibility of an additional rate hike even without inflation accelerating, simply because it is falling too slowly while demand holds up. Encouragingly, long-term inflation expectations have remained stable, a sign that markets trust the Fed to keep longer-run inflation in check. For investors, the key question is how much tightening is currently priced into the market. Pricing now implies roughly four to five quarter-point Fed hikes in this cycle, including September’s. That represents a stark reversal from the start of the year, when some investors were concerned that Chair Warsh might cut rates due to political pressure. In more recent months, interest rates have also moved closely with oil prices, so any meaningful easing in energy prices could bring relief to bonds. Even so, we believe the resilience of the economy will keep yields above the levels seen for much of the 2010s.

Median FOMC Projection for Fed Funds Rates

Endnotes

¹ U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) sourced from FRED.

² U.S. Federal Open Market Committee and Federal Reserve Bank of St. Louis, FOMC Summary of Economic Projections for the Fed Funds Rate, Median sourced from FRED

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