At the September meeting, Fed officials hiked the fed funds rate by 75 basis points (bps) and provided their most resolute messaging to date on their willingness to do whatever it takes to battle inflation. Stronger, stickier, and broader-based U.S. inflation since the Fed last shared forecasts in June argued for a much steeper rate-hiking path, and the Fed delivered by upgrading the rate trajectory for 2022 and 2023 by 75 to 100 bps.
Given tighter financial conditions and a higher fed funds rate, we believe the path to a soft landing continues to narrow. Chair Jerome Powell acknowledged this by admitting some economic pain would be necessary to moderate inflation back to target. We continue to believe that this ultimately means a U.S. recession is more likely than not over the next 12 months, although Fed officials’ projections still reflected something like a soft landing, with a median outlook of modestly below-trend growth and unemployment only slightly above estimates of NAIRU (the nonaccelerating inflation rate of unemployment).
Looking ahead to the remaining meetings in 2022, we believe the rate path forecasts imply another 75-bp hike is likely in November, before the pace slows to 50 bps in December as the Fed nears a terminal rate in early 2023.
Looking further out, while the Fed was clear that it is willing to accept the near-term economic costs of bringing inflation down, most Fed officials were also forecasting rate cuts starting in 2024, as lower inflation and a higher unemployment rate could make the trade-off between battling inflation and accommodating growth more challenging as the Fed looks to ease the policy rate back to neutral.
Stickier inflation, steeper hikes
The macro outlook has evolved meaningfully since Fed officials last submitted forecasts following their June meeting. The inflation picture worsened: Of the three alarmingly hot U.S. CPI (Consumer Price Index) prints in recent months, only one was known during the June meeting. Inflation now looks stickier and broader-based across components of the CPI price basket (see our blog post on the August CPI numbers), wage inflation has accelerated further, and on net, inflation expectations have ticked higher. Meanwhile, the activity data has shown an economy that reaccelerated after a weak patch in May and June, while the labor market has appeared particularly resilient in the face of macro developments, including elevated energy market volatility and tighter financial conditions.
As a result, the Fed hiked the policy rate 75 bps and meaningfully adjusted higher its outlook for interest rates for 2022 and 2023 (with upward revisions of 75 bps to 100 bps, now reaching a projected median terminal rate of 4.6%). While the Fed did not project a contraction in real U.S. GDP over its forecast horizon, in our view, it appears increasingly likely that economic contraction, and a more meaningful move higher in the unemployment rate, may be exactly what will be needed to bring down inflation. Recent estimates from the San Francisco Fed put NAIRU at 6%, suggesting that a larger rise in the unemployment rate may be needed to re-anchor inflation. (U.S. unemployment came in at 3.7% in August, according to the Bureau of Labor Statistics.)
While Fed officials have acknowledged that they expect below-trend growth will be needed to cool inflation, it would be difficult for any central bankers to admit they are aiming for a recession. In this context, it’s perhaps not surprising that Fed policymakers apparently still viewed the balance of risks around inflation as weighted to the upside. Elevated inflation has kept real interest rates low, despite generally tighter financial conditions. And with inflation now broadening, it seems much less clear that inflation will moderate on its own without additional monetary tightening to bring real interest rates above their neutral levels. Indeed, the risk of second-round effects of higher inflation contributing to rising inflation expectations and so on appears more acute in the context of inflationary trends that now appear broader than just pandemic-related supply shocks.
Given this background, we believe the Fed will remain squarely focused on fighting inflation in the months ahead. The rate path forecasts suggest to us another 75-bp hike should be expected in November, before the pace slows to a still-accelerated speed of 50 bps in December as the Fed approaches a terminal rate in early 2023. We believe stickier inflation argues that the Fed will likely leave the policy rate on hold at this restrictive level for some time, before the economy ultimately slows and the trade-off between inflation and unemployment becomes more challenging.
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