"Slowing Down but Raising Higher" US Fed Signals Era of 5% Benchmark Interest Rate [Comprehensive Report 2]

[Asia Economy New York=Special Correspondent Joselgina] The U.S. central bank, the Federal Reserve (Fed), has implemented the so-called 'Giant Step' of raising the benchmark interest rate by 0.75 percentage points four consecutive times. While signaling a future slowdown in pace, it declared that the terminal rate will be higher, effectively heralding the '5% benchmark interest rate era.'

With this Giant Step, the upper bound of U.S. interest rates jumped to 4.0%, the highest level since 2008, expanding the interest rate gap with South Korea to a maximum of 1.0 percentage point. In South Korea, which is experiencing tightening in the capital market, concerns over capital outflows and the depreciation of the Korean won have intensified.

◆ Powell Draws the Line on Rate Hikes but Leaves Room for Pace Adjustment

On the 2nd (local time), the Fed announced after the Federal Open Market Committee (FOMC) regular meeting that it would raise the federal funds rate by 0.75 percentage points from the previous 3.0?3.25% to 3.75?4.0%. The unanimous decision to implement an unprecedented four consecutive Giant Steps came as inflation showed little sign of easing despite aggressive tightening.

The Giant Step was a sequence long anticipated by the market. The September Consumer Price Index (CPI) released last month rose 8.2% year-on-year, raising concerns about entrenched inflation, and recent employment data supported a strong labor market.

Summarizing Fed Chair Powell’s press conference immediately after the FOMC meeting in one sentence: "Slow down the pace, but raise rates higher and maintain them longer." From the start of the press conference, questions about slowing the pace of rate hikes poured in. Since four consecutive Giant Steps had been anticipated, the market’s focus was on the size of hikes after December.

Powell said at the press conference, "It is very premature to think or talk about stopping rate hikes," adding, "We have a way to go." He emphasized, "As rates move into restrictive territory, 'how high' and 'how long' are more important than 'how fast,'" reaffirming that tightening will continue for some time, saying, "There is still some ground to cover before we judge that we have reached an appropriate rate level."

He also indicated that the terminal rate would be higher than previously expected in the September dot plot, effectively signaling the era of benchmark rates at 5%. He added that "overtightening is easier to correct than undertightening."

However, Powell left room for the possibility of slowing the pace of hikes. He said, "I have said it would be appropriate to slow the pace of rate hikes, and that time is approaching," mentioning that this could happen as early as the next meeting (December) or the following one (January). He added, "Nothing has been decided yet," noting that it depends on upcoming data and economic impacts. While leaving the door open for pace adjustment, he confirmed a tightening stance based on data similar to previous FOMCs.

Mike Feroli, Chief Economist at JP Morgan, described the FOMC as "Slower for longer." The Fed may ease the size of rate hikes starting next month but raise the terminal rate to a higher level and maintain it for a long period. ING also reported that "the outlook for the pace of rate hikes has been lowered, but the duration is expected to be longer."

Additionally, Powell assessed at the press conference that there is no clear evidence that inflation is definitively falling and that the labor market remains generally overheated. Regarding U.S. consumption, he said, "Consumers have purchasing power and are doing okay." While noting that the possibility of a soft landing for the U.S. economy has diminished, he still believes it is possible.

[Image source=AP Yonhap News]

◆ Terminal Rate Upgrade Forecast, U.S. 5% Era Foreseen

Wall Street is evaluating that the Fed’s decision to implement four consecutive Giant Steps effectively signals the '5% benchmark interest rate era.'

Powell’s remark that "the terminal rate could be higher" is expected to be reflected in the dot plot next month. The September dot plot previously projected a terminal rate of 4.5?4.75% (median 4.6%) for next year.

Citibank immediately raised its terminal rate forecast from 5.0?5.25% to 5.25?5.5%. Citi explained, "The Fed clearly signaled a preference for overtightening, sending a hawkish message," and that the expression "there is still a way to go" also implies rates will be higher than the dot plot suggests. JP Morgan also expects the December dot plot to be revised upward for the same reasons. Currently, the interest rate futures market reflects over a 60% chance that U.S. rates will exceed 5.0% by March next year.

Before the press conference, the statement included the phrase "considering the cumulative effects of tightening monetary policy, lags in monetary policy’s impact on economic activity and inflation, and economic and financial developments," which briefly raised market expectations for policy adjustment.

Regarding this, Jack McIntyre, Portfolio Manager at Brandywine Global, said, "Powell’s remarks were quite hawkish," and that mentioning the lagged effects of cumulative tightening in the statement suggests flexibility to slow the pace rather than a policy shift.

RBC noted that Powell mentioned the terminal rate before the December Summary of Economic Projections (SEP) release and assessed that "the dovish content related to pace adjustment in the statement turned into a hawkish meeting due to the mention of a possible terminal rate increase."

Opinions are divided on the last meeting of the year, the December FOMC. According to the Chicago Mercantile Exchange (CME) FedWatch, the probability of a big step (0.5 percentage point hike) in December reflected in the rate futures market rose to 56.8% from 44.5% the previous day. However, with inflation still high and the Fed’s hawkish stance continuing, the possibility of continuing Giant Steps until December (43.2%) also exceeds 40%. Morgan Stanley noted, "Powell did not provide clear guidance on the size of the next hike, but the possibility of a 0.5 percentage point increase has grown due to hints at slowing the pace," adding, "However, this depends on upcoming economic data."

◆ U.S.-South Korea Interest Rate Gap Widens... Bank of Korea Also Expected to Raise Rates on the 24th

With the Fed’s rate decision, the interest rate inversion between South Korea (3.0%) and the U.S. widened to 0.75?1.0 percentage points, matching levels seen during the last inversion period from March 2018 to February 2020.

The interest rate gap between the two countries had widened to a maximum of 0.75 percentage points during the Fed’s third Giant Step in September, then narrowed to 0.25 percentage points after the Bank of Korea’s big step (0.50 percentage point rate hike) on the 12th of last month. However, with the Fed’s latest move, the gap expanded again to 1.00 percentage point.

If this U.S.-South Korea interest rate inversion persists long-term, capital outflows by foreign investors and won depreciation in South Korea are inevitable. Moreover, won depreciation is also considered a factor that fuels inflation.

Accordingly, the Bank of Korea is also expected to raise the benchmark interest rate on the 24th. This would mark the sixth consecutive hike. Initially, the market considered the possibility of the Bank of Korea slowing the pace (from big step to baby step) due to concerns about economic slowdown and capital market tightening triggered by the Legoland incident, but given the growing interest rate gap, the likelihood of another big step is gaining weight again.