Does the potential end of the Fed rate hike cycle signal a near-term pivot toward lower rates?

As widely expected, the Fed announced another 0.25% rate hike in its benchmark funds rate yesterday, marking the 10th consecutive rate increase in as many meetings. This latest rate hike brings the cumulative increase to 5% in just over a year, potentially capping a historically aggressive tightening cycle.

While the Fed’s policy rate is now at its highest point since 2007, in real (inflation-adjusted) terms, the fed funds rate has only recently risen into positive territory. Except for a brief period in 2019, real short-term rates have been negative for over a decade. However, even if rates hold steady from here, real rates are likely to rise over the remainder of the year if inflation edges lower as expected, further tightening financial conditions.

So what’s next for monetary policy? The recent softening in the Fed’s tone suggests that policymakers are ready to pause to gauge the effect of the collective tightening to date while leaving the door open to additional rate increases if inflation doesn’t ease meaningfully in the coming months. A pause is very different from committing to a near-term reduction in rates though, as they still prefer the ambiguity of preserving all options to ensure that policy objectives can be met. The futures market doesn’t see it that way and continues to price in a probable half-percent cut by year-end. Growing recession risk, tighter credit conditions, and banking sector turmoil all contribute to that view. That gap in expectations will be resolved as the near-term direction for growth and inflation become clearer.

The bottom line? The Fed may pause, but real short-term rates have further room to rise if inflation eases as expected. Such an outcome would equate to further tightening, even if the Fed stands pat.