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Fed Holds Interest Rates Steady, Keeps Policy Options Open

In our view, the Fed’s inflation and labor market concerns are overstated, and additional rate hikes won’t be necessary.


Key Takeaways

Amid moderating inflation and rising Treasury yields, the Fed left interest rates unchanged again but stopped short of ending its tightening program.

Labor market strength, wage growth and still-high consumer prices are keeping policymakers on edge and data-dependent.

We expect the lag effects of higher interest rates and inflation to weigh on the U.S. economy, encouraging the Fed to end its rate-hike campaign.

Continued progress in controlling inflation prompted the Federal Reserve (Fed) to once again hold interest rates steady at a 22-year high. Wednesday’s decision marked the Fed’s second consecutive pause — and the third overall — in its 19-month tightening campaign.

Third-Quarter Growth Is Likely Unsustainable

The Fed paused despite robust economic growth, suggesting the government’s latest gross domestic product (GDP) data may reflect an anomaly. In its first estimate of third-quarter economic output, the Commerce Department reported the economy grew 4.9% (annualized), the fastest pace in nearly two years. But the surge was largely due to consumers’ summer spending sprees and a jump in inventory investments, which likely aren’t sustainable.

A still-strong labor market and persistent above-target inflation have largely accounted for the Fed’s hawkish tone. However, since raising short-term interest rates to a range of 5.25%–5.5% in July, policymakers have adopted a wait-and-see approach to additional increases. In our view, the compounding effects of higher rates and consumer prices ultimately will stifle the labor market and the economy, flipping the Fed.

Surging Treasury Yields Are Helping Slow the Economy

While the Fed left its future policy options open, we believe the central bank’s tightening campaign is likely over. With Treasury yields soaring recently to 16-year highs, the bond market is doing its part, alongside the Fed, to tighten financial conditions. The yield on the 10-year Treasury note, a benchmark for mortgage and other consumer lending rates, recently topped 5% for the first time since 2007.

Also, as we’ve noted previously, it takes time — 18 months on average — for Fed tightening to slow down the economy and inflation. We believe this timeline is closing, and the cumulative effects of higher interest rates and consumer prices ultimately will tip the economy into recession.

All Eyes Are on the Labor Market

The labor market is a main factor guiding the Fed’s holding pattern. Resilient job creation and the relatively low unemployment rate continue to fuel inflation worries and complicate its interest rate outlook.

As Figure 1 demonstrates, annual wage growth has moderated this year, easing to 4.2% at September-end from a post-pandemic high of 5.92% in March 2022. But wages are still rising faster than the pace consistent with the Fed’s 2% target inflation rate. Furthermore, high-profile union strikes and associated hefty wage demands highlight the Fed’s ongoing labor-related inflation concerns.

Figure 1 | Wages Are Still Growing but at a More Modest Pace

A line graph showing average hourly earnings from October 2018 through September 2023. Average hourly wages are up almost 1% since 2018, but the Fed still has ongoing labor-related inflation concerns.

Data from 10/31/2018 – 9/29/2023. Source: Bureau of Labor Statistics, LSEG, FactSet.

Union Demands Capture Headlines

The unprecedented combination of events since 2020, including pandemic-related shutdowns and the highest inflation rate in two generations, helped trigger today’s resurgence in labor strife. From Hollywood writers and actors to employees in the health care, hospitality and automotive industries, union strikes have dominated headlines in 2023.

Through the first nine months of 2023, strikes have led to 11 million lost workdays, according to the U.S. Department of Labor. This is more than five times the losses of 2022 and the highest since 2000 when union membership was 3 percentage points higher than today.

One of the highest-profile labor disputes pitted the United Autoworkers Union (UAW) against the Big Three automakers. After hitting the picket lines for more than six weeks, union employees recently reached tentative deals with management teams at Ford Motor, General Motors and Stellantis. The 4.5-year proposed agreement gives UAW members a 25% wage increase, cost-of-living adjustments and pension improvements, among other key provisions.

The total cost of an agreement with the UAW and other unions likely will be substantial. For companies that have struggled to reach double-digit operating margins in good times, soaring labor costs will weigh on margins. In our view, this dynamic likely will have negative near-term consequences for the broad economy and further support our recession outlook.

Rising Wages Drive Structural Shifts for the Economy and Inflation

In our view, mounting conflicts between management and labor underscore an unfolding structural economic shift over the coming years. Growing demands for higher wages across industries will likely reshape the capital/labor relationship to favor labor over capital.

This pending dynamic also supports our long-term inflation view. With labor taking precedence, inflation likely will settle higher than the Fed’s current 2% target. We expect this trend to emerge over the next three to five years and persist from there.

But over the next year or two, we believe tighter financial conditions and an eventual recession should continue to constrain inflation. Although consistent labor wage gains inflate prices over time, the near-term effects of higher incomes should be limited in today’s economy. We don’t expect recent salary gains to diminish the economic fallout from high interest rates and tighter lending standards.

Maintain Your All-Weather Investment Strategy

In periods of heightened market and economic uncertainty, we encourage you to remain disciplined and focused on your long-term investment plan. Investing across multiple asset classes with professional investors skilled in risk management may be prudent in the current market climate.

Our investment teams have been anticipating an economic slowdown and positioning our portfolios accordingly. Given our outlook for recession, we believe emphasizing higher-quality equity and fixed-income securities remains warranted.

It’s also important to remember that attractive investment opportunities often emerge during market unrest. We suggest investing with experienced professionals with the insights and discipline to recognize and potentially capitalize on such prospects.

Charles Tan.
Charles Tan

Co-Chief Investment Officer

Global Fixed Income

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