Inflation in the USA has caused more market volatility than the combined effects of the FOMC decision, forecast updates, and the post-meeting press conference. Despite the median expectations of American policymakers indicating that we can expect only one rate cut this year (as opposed to the three predicted in March), market sentiment improved due to a positive surprise in the CPI report. Yesterday, the Wall Street stock market turned green, and the US dollar lost value. US bond yields experienced a significant decline.
This was expected to be a day of heightened volatility in financial markets, and it indeed was. The market reacted most strongly to the inflation data, while the hawkish press conference and forecast updates indicating fewer cuts this year did not provoke as much emotion. As expected, the Fed did not change the level of key interest rates. The fed funds rate still indicates 5.25-5.5%, maintaining this high level since July 2023, marking the seventh consecutive decision without changes. Only in 2000-2001 did the Federal Reserve maintain the cost of money at the peak for longer. The unanimous decision indicates that there is no doubt within the central bank that it is not yet time to ease monetary conditions.
The market initially weakened the dollar due to lower values in the May inflation report, and then moved on to assess other points. The decision itself could not affect volatility as it was fully discounted. New information was expected in the FOMC’s official statement, which saw cosmetic changes. There was a slightly more optimistic view on inflation development. While in May it was stated that there had been “no further progress” towards the inflation target in recent months, the Fed now sees “moderate further progress.” However, this did not impress market participants, especially after seeing evidence of weakening inflationary pressure a few hours earlier. The fact that the Federal Reserve acknowledges and communicates this surprises no one.
More surprises were quietly anticipated in the updated “dot plot.” The market knew that inflation in the first quarter had been a negative surprise and that the change in the median expectations of FOMC members should indicate fewer cuts this year. The dot plot suggests one move in the next six months, a hawkish change that theoretically should have strengthened the dollar. This would have likely happened if not for the hard CPI numbers, which turned out to be the biggest “trigger” for changes. In detail, the majority (11 out of 19 meeting participants) expect at most one rate cut this year, and none expect three. The assessment of the long-term interest rate has risen again, from 2.6% to 2.8%.
Next came Powell’s speech and questions from journalists. The Fed Chairman directly referred to the dot plot and acknowledged that both one and two cuts are possible. Remember, the dot plot is not binding for policymakers; it is merely a market guideline and a baseline scenario that can, of course, change. The fact that meeting participants currently expect fewer cuts than in March is due to an upward revision of the inflation forecast for this year. Powell linked further decisions to incoming data, which is currently the standard approach for most central banks. The chairman admitted that the May CPI data was positive but did not want to place too much emphasis on a single report. He clearly stated that a series of lower readings is needed to confirm the strength of the downward trend.
Powell has once again demonstrated that the Fed’s approach and conduct of monetary policy must be exceptionally cautious, and it likely will remain so. It is evident that the chairman prefers to ease later rather than too soon to avoid changing course again, which would be perceived as a mistake. Times have changed, and the economy looks a bit different, but in the back of everyone’s mind are the events from over 40 years ago when Paul Volcker, the then head of the Federal Reserve, made the mistake of lowering rates too early. This was partly due to increasing public pressure. Consequently, inflation grew even more, forcing the institution to tighten further. The consequences of these actions proved devastating for the American economy.
Łukasz Zembik, Oanda TMS Brokers
