Macro Insights Weekly: Fed cycle to get longer

Three key data releases in the past week have compelled us to tweak our Fed funds forecast. We now expect a terminal rate of 5.25% and no more than 100bps in rate cuts next year.
Group Research, Taimur Baig, Samuel Tse20 Feb 2023
  • First, headline and core CPI releases for January suggest a stickier inflation path.
  • Second, January retail sales point to rebounding economic momentum.
  • Third, January PPI data indicate firms still facing price pressure and have pricing power.
  • These developments support the higher for longer narrative.
  • A stronger dollar is likely to be an additional outcome.
Photo credit: Adobe Stock Photo

Commentary: Fed cycle to get longer

We haven’t touched our Fed forecasts since the 3Q of last year, as the large rate hikes of 4Q and the smaller hikes of 1Q23 were well-transmitted by the Fed and understood by the markets. Inflation and growth momentum were waning, but the Fed’s job was far from over with inflation in still-high single digits.

But even as we held our forecasts unchanged, a major gap began to emerge between the Fed and the markets. Despite Fed officials communicating their keenness to keep rates high for an extended period, the markets began to take on the view that the economy will respond to the rate hikes of 2022 with a sharp slowdown in 2023, which would necessitate rate cuts by 4Q23. The view also reflected expectations of sharp disinflation through the course of this year.

This divergence, between Fed dot-plots suggesting no cuts at all in 2023 and various market-based pricing projecting a far more dovish outcome, was clearly unsustainable. Many times in the past, the “smart money” that drives fixed income pricing, has proven to prescient. This time though, the market’s bet is quite not working out.  

Three key data points released last week have challenged the markets considerably. The headline CPI rose by 0.5% in January, while the core CPI rose by 0.4%, as energy, food, shelter, and some other prices reversed the recent cooling trend. Coming on the back of the 517k January payrolls print released during the previous week, this prompted Dallas Fed president Logan to state last week that continued rate hikes for a longer period than previously anticipated was on the table.

A key point made in Ms. Logan’s speech was that recent decline in goods prices reflect improvement in supply chain conditions and little more, which is a source of limited comfort as “supply chains can’t recover twice.” Additional risks to goods prices in the coming month stem from Europe, which looks set to avert a recession, and strong ongoing rebound in China with the end of the “zero-Covid” policy.

Also released last week was January retail sales data (+3%mom), which was surprisingly strong, adding to the evidence that economy is picking up momentum. Accordingly, the AtlantaFed Nowcast is now tracking 1Q GDP growth in the 2.5% range. Manufacturing output has picked as well, with firms picking up cues from reviving demand for cars, furniture, appliances, and restaurants. Relatively warm weather has supported this trend.

Late in the week came the producer price data, which turned out to be the third salvo against the dovish camp. While the PPI is no longer in the double-digit annual growth territory like it was last summer, it is still up 6%yoy, held up by a 0.7%mom rise last month. Producer prices are capturing two dynamics: first, firms are still facing high cost of production, including from wages and material inputs; second, they are finding demand strong, which makes them more amenable to hike prices.

With this backdrop, we now think the Fed will hike by 25bps both in March and May, taking the terminal rate to 5.25%. We also think the market pricing of 150bps+ in rate cuts next year is unlikely to materialise. High real and nominal rates will slow growth and inflation, but only enough to justify at most 100bps in rate cuts in 2H24, in our view. It’s higher for longer.

Taimur Baig

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Taimur Baig, Ph.D.

Chief Economist - Global

Samuel Tse 謝家曦

Economist - China & Hong Kong 經濟學家 - 中國及香港

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