Lord Abbett: The Fed Finds Cause For A Pause

On May 3, 2023, the Federal Open Market Committee (FOMC), the policy-setting arm of the U.S. Federal Reserve (Fed), raised the fed funds rate by 25 basis points (bps), establishing a target range of 5–5.25% for the benchmark rate. This marked a total of 500 bps of rate hikes since the central bank’s policy-tightening program began in March 2022.

While the rate hike was widely expected by the market, the key development at the May policy meeting was a tweak to language in the post-meting statement. In March, the FOMC said it “anticipates some additional policy firming may be appropriate.” In the May statement, policymakers referred to “determining the extent to which additional policy firming may be appropriate.”  Citing modestly expanding economic activity and elevated inflation, the Fed stressed its commitment to achieving maximum employment and returning inflation to its 2% objective.

In a post-meeting press conference, Fed Chair Jerome Powell emphasized the “meaningful change” in the policy statement, stating that decisions on further tightening would be made on a meeting-to-meeting basis and a potential pause could be decided at the June meeting. Powell believed that a “soft landing” for the economy is still possible, though he acknowledged that Fed members’ own forecasts indicate greater odds of a recession later this year.

Powell acknowledged the soundness and resilience of the U.S. banking system, citing improvements in banking-sector conditions since early March. (The Fed chair’s statement came ahead of fresh weakness in shares of U.S. regional banks after news that California-based lender PacWest Bancorp said it is in talks with several potential investors.) Powell also highlighted the tight U.S. labor market, with some signs of supply and demand achieving better balance. Powell addressed the potential risk of reaching the U.S. debt ceiling, reiterating that the Fed cannot shield the economy from the consequences of failing to increase it.

The Fed’s decision to continue raising interest rates led to a negative reaction in the stock market, and a rally in U.S. Treasury bonds on May 3.

The altered language around “policy firming” would appear to change the optionality for the next FOMC meeting from an option to tighten to an option to pause. Of course, whether that option is exercised is dependent on economic data released between now and the next meeting. The “soft landing” Powell spoke of is still possible, as declining job vacancies and a stable unemployment rate indicate that the pressure could come off labor demand enough to bring wage inflation down without a recession. However, labor costs have been increasing at about a 5% rate; that is about 2% above the rate that’s consistent with the Fed’s 2% inflation target, indicating that declining levels of job vacancies by themselves may not be enough to ease labor market pressure sufficiently. Powell’s optimism on a soft landing is possible contrasts with forecasts from Fed members of decreasing inflation and rising unemployment, creating a discrepancy between monetary policy and economic forecasts.

An official pause in Fed rate hikes, whether it occurs at the June FOMC meeting or at some other time, could present a positive backdrop for risk assets. Many investors are appropriately cautious given the current uncertainty, and we agree that concentrated bets may not be appropriate. Rather, we encourage a more balanced approach that can succeed in a variety of scenarios. An emphasis on high-grade fixed income, along with a blend of money market, short-term, and intermediate term bond strategies, may be a sensible path.  Within credit, flexible, multi-sector strategies may be in a good position to navigate the current environment; the generally cautious investment backdrop may also be creating some compelling investment opportunities, which is a favorable setting for more opportunistic credit strategies. And within equities, a focus on quality is key.