Fed review: 5% Funds rate in play
The key message from the September meeting of the US Federal Reserve’s Open Market Committee was not the widely expected, unanimously voted, 75bps rate hike, taking the top end of the target rate to 3.25%. Instead, it was the extraordinary ratcheting up of hawkishness. US Federal Reserve officials have raised their policy rate forecasts by 100bps between June and September of this year. This shift, as indicated by the “dot-plot” of their projections, puts a terminal rate of around 5% in play, something that was unthinkable by most. This is especially the case since growth projections worldwide have been revised down in recent months, commodity and shipping prices have corrected considerably, and interest rates are already above what is widely considered to be the neutral rate.
But in their frustration with sticky core inflation, the focus of the Fed officials has shifted decidedly toward wages and shelter, which, by extension, makes the rate of unemployment the key outcome to watch. The prevailing rate (3.7%) is considered way too low, and if a recession or near-recession like conditions are warranted to push it above 4%, Fed officials are willing to entertain that. We gleaned that message from Chair Powell’s press conference remarks after the FOMC meeting.
As we discuss the Fed Funds rate going from 3% to 4% and beyond, some perspective is warranted about the profound shift in the monetary policy landscape. Just a year ago at this time, the Fed was signalling that rates might stay near zero for another year, and it was purchasing Treasury and mortgage securities to provide additional stimulus. Now 75bps hikes have become near-routine, along with substantial and steady withdrawal of liquidity from the markets.
We now expect another 75bps rate hike in the next meeting (November 2), followed by a 50bps rise (December 14), taking the end-2022 Fed Funds rate to 4.5%. It is conceivable that both economic and financial conditions will have tightened sufficiently by then to warrant a lengthy pause thereafter, but given the Fed officials eagerness to cool down the labour market, they may remain on the path of some additional tightening in Q1 as well. We are therefore pencilling in 50bps of further rate hikes between the February and March meetings, but only with even odds.
Implications for growth and inflation are clear; this type of tightening will soften hiring and activities, with core PCE inflation easing through 2023 to below 3% toward the end of the next year. Growth will be 1% or lower, and joblessness will rise. Will a million and a half Americans have to lose their jobs (pushing up unemployment toward 4.5%) to bring inflation down to comfortable levels? We fear so.
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