Fed pauses but leaves the door open for more rate hikes

Important calendar events

• GBP: Public Sector Net Borrowing, Monetary Policy Summary, MPC Official Bank Rate Votes, Official Bank Rate, BOE Inflation Letter
• USD: Unemployment Claims, Philly Fed Manufacturing Index, Current Account, Existing Home Sales, CB Leading Index

USD

The dollar gained strength on Wednesday after the Fed interest rate announcement and the dollar index climbed to the 105.3 level. US Treasury yields also strengthened on increased rate hike expectations, with the US 10-year bond yielding above 4.35%. 

FOMC members unanimously voted on Wednesday to keep interest rates unchanged at a target range of 5.25% to 5.50%. The Fed decided to pause rate hikes but that does not necessarily mean it has reached its rate ceiling. 

The Fed policy statement following the meeting left the door open for further rate hikes. Market odds of another rate hike within the year are increasing, although it is clear that the Fed’s future policy direction will be data-driven.

Market participants focused especially on FOMC Economic Projections on Wednesday. US policymakers upgraded the US GDP outlook to 2.1% from 1.0% for 2023. Inflation was forecast to decrease further, with core PCE for 2023 expected to drop to 3.7% from previous estimates of 3.9%. The US economy is showing signs of picking up, giving the Fed more leeway to raise interest rates. At the same time, inflationary pressures are proving quite stubborn and may force the Fed to continue its hawkish policy.

Particularly illuminating was the Fed’s so-called dot plot, which illustrates the anticipated trajectory of borrowing costs as envisioned by Fed officials. The interest rate projection for 2023 stayed unchanged at 5.6%, signaling another rate hike within the year.

US inflationary pressures are not easing just yet, despite the Fed’s high-interest rates. PPI rose by 0.7% in August, exceeding expectations of a 0.4% rise. Core PPI, which excludes food and energy, decelerated a little, rising by 0.2% in August compared to a 0.4% growth in July. Rising fuel costs are largely to blame for the stubbornly high inflation rates in the US. 

Consumer inflation is also accelerating, with CPI rising by 0.3% in August from 0.2% in July against expectations of a 0.2% print. Headline inflation came in hotter than anticipated, climbing to 3.7% year-on-year in August from 3.2% in July versus 3.6% anticipated. Core inflation, which excludes food and energy, also rose by 0.3% in August from 0.2% in July. Increasing price pressures may push the Fed to continue its hawkish policy until inflation drops closer to the Fed’s 2% target.

Preliminary GDP for the second quarter of 2023 showed that the US economy expanded by only 2.1% against expectations of 2.4% growth. The preliminary GDP price index for the 2nd quarter of the year also came in below expectations at 2.0% versus 2.2% anticipated.

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EUR 

EUR/USD plummeted after the conclusion of the Fed meeting on Wednesday, dropping to 1.066. If the EUR/USD pair declines, it may find support at 1.063, while resistance may be encountered near 1.076. 

Headline inflation in the Euro Area dropped slightly to 5.2% year-on-year in August from 5.3% in July. Flash CPI estimates had shown that annual CPI had remained unchanged from July at 5.3%. Core CPI, which excludes food and energy, dropped to 5.3% from 5.5% in July. 

The ECB raised interest rates by 25 bp at last week's monetary policy meeting, bringing its main refinancing rate to 4.50%. The ECB had the difficult task of assessing the risk to the fragile Eurozone economy against high inflation rates. In the end, persistently high inflation induced the central bank to raise interest rates again on Thursday. 

The ECB hinted that it had reached its interest rate ceiling, putting pressure on the Euro. ECB President Christine Lagarde signaled an end to rate hikes at the press conference after the conclusion of the meeting but warned that interest rates will remain at sufficiently restrictive levels for as long as necessary.

Final GDP data for the Euro area were disappointing, showing that the Eurozone economy expanded by only 0.1% in the second quarter of the year against expectations of 0.3% growth. The Eurozone economy barely expanded in the second quarter after contracting by 0.1% in Q1 of 2023. The EU economy is struggling and cannot withstand much further tightening. 

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GBP 

GBP/USD gained strength in early trading on Wednesday. The currency rate dropped sharply after the Fed rate decision buoyed the dollar, however, touching the 1.234 level. If the GBP/USD rate goes up, it may encounter resistance near 1.255, while support may be near 1.231. 

The Sterling is expected to exhibit increased volatility on Thursday, as the BOE announces its interest rate decision. The BOE is seen as likely to continue raising interest rates and markets are pricing in another 25-bp rate hike on Thursday. 

Thursday’s interest rate decision is unlikely to be unanimous as in recent votes some MPC members were more dovish than others. Nevertheless, market odds are in favor of yet another rate hike in November and a lot is riding on the forward guidance the BOE will give this week. The BOE rate votes on Thursday as well as the Monetary Policy Summary will be scrutinized by traders for hints into the central bank’s future policy direction.

British Inflation cooled more than expected on Wednesday, demonstrating the effectiveness of the BOE’s consistently hawkish policy. Headline inflation dropped to 6.7% year-on-year in August from 6.8% in July against expectations of 7.0%. Core CPI, which excludes food and energy, dropped significantly, indicating that rising fuel costs are largely to blame for sticky inflation in the UK. Core CPI dropped to 6.2% on an annual basis in August from 6.9% in July against 6.8% expected.

Even though inflationary pressures in the UK are easing, inflation is still high, and policymakers are likely to continue raising interest rates to bring it closer to the BOE’s 2% target. The BOE raised interest rates by 25 basis points at its latest policy meeting, bringing the bank rate to a 15-year high of 5.25%. 

Britain’s economy contracted by 0.5% month-on-month in July after expanding by 0.5% in June. The prognosis was more optimistic, with markets forecasting a 0.2% decline in GDP. The state of the British economy is fragile, as prolonged tightening has taken its toll on the labor market and other vital economic sectors. The British economy weakened more than expected in July and this may play a decisive role in the BOE’s monetary policy decision this week.

A combination of a struggling economy and high inflation is making the BOE’s task more difficult. Further tightening is needed to bring inflation down at the risk of tipping the British economy into recession. 

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JPY

The dollar soared on Wednesday and USD/JPY shot upwards, testing the 148-level resistance. If the USD/JPY pair declines, it may find support near 145.8. If the pair climbs, it may find further resistance at 149. 

The balance of trade data released on Wednesday for Japan was disappointing. The value of imported goods in August exceeded the value of exported goods by 0.56T versus 0.44T expected.

The BOJ maintained its short-term interest rate target steady at -0.10% at its latest policy meeting in July but loosened its yield curve control. 

Another BOJ monetary policy meeting will be held on Friday. The ECB already hiked rates one more time last week and the BOE is likely to follow suit on Thursday. Even though the Fed kept interest rates steady this week, the US central bank delivered a hawkish message hinting at more rate hikes within the year. The Yen becomes even more vulnerable as other major central banks continue raising interest rates. 

The BOJ is almost certain to maintain its negative interest rate on Friday. Markets, however, will be focused on the BOJ’s forward guidance as the central bank is finally showing signs of relaxing its ultra-easy policy.

BOJ Governor Kazuo Ueda hinted last week that a policy shift may finally be on the horizon. Ueda admitted the BOJ will be exploring new policy options if economic and price conditions continue moving upward. Ueda warned that the present ultra-easy policy will continue for some time but indicated that the BOJ is considering policy adjustments further down the track. 

The Yen has been weakening, pushed down by the BOJ’s ultra-accommodating monetary policy. The Yen’s weakness has been the subject of concern for Japanese authorities as it undermines the country’s importing potential and causes financial distress in households. 

Japanese authorities have been repeatedly warning speculators against excessive short-selling of the Yen. The Yen’s continued weakness is raising market awareness of another intervention by the Japanese currency to support the ailing currency. Many market analysts view the USD/JPY 150 level as the line in the sand for another intervention.

National Core CPI dropped to 3.1% in July from 3.3% in June. Inflation in Japan has remained above the BOJ’s 2% target for more than a year, encouraging the BOJ to tighten its monetary policy. BOJ Core CPI dropped slightly to 3.0% in July from 3.1% in June. 

Final GDP data for the second quarter of the year showed that the Japanese economy expanded by 1.2%, disappointing expectations of 1.4% growth. The final GDP Price Index showed a 3.5% annual expansion, versus 3.4% the previous quarter. Japan’s economic recovery increases the odds of a hawkish pivot in BOJ’s monetary policy.

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Written by:
Myrsini Giannouli

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