United States
The Federal Reserve, as expected, announced a “downshift” in its policy tightening. It raised the upper bound of its policy rate by 50bp, from 4% to 4.5%, following four consecutive 75bp hikes.
The Fed was, however, clear that it still has more hiking to do in 2023. Fed Chair Powell stated that rates are still “not sufficiently restrictive”. In our view, this confirms that, contrary to market expectations, rate cuts are a long way off.
As the Fed moves to keep policy and market conditions tighter, we believe investors need to be prepared for market volatility to continue.
A higher “terminal rate” is in the cards
The Fed once again raised its “dot plot” projections, albeit to a lower extent than they have at each quarterly meeting this year, indicating that its policy expectations are stabilizing (Figure 1).
Figure 1: The Fed raises rate expectations for potentially the last time1
The Fed's most notable (and most anticipated) change was to its 2023 year-end forecast, now at 5.125%, up from 4.65%. Only two of the 19 voting members projected a lower rate (at 4.875%).
This is a strong indication that the committee expects to raise rates another 50-100bp over the coming months, perhaps through a mix of a 50bp hike and smaller 25bp hikes.
We believe this downshift in hikes is justified as today’s move puts policy rates in touching distance of the rate level implied by a modified version of the Taylor Rule (Figure 2).
Figure 2: Fed Funds Rates are now in touching distance of Taylor Rule-implied rates2
Notably, the Fed is also sending a clear message that it is willing to tighten further than the Taylor Rule suggests, having been “behind the curve” for some time.
The Fed’s refreshed projections indicate that it sees rising growth risks
The Fed’s quarterly summary of economic projections reflected rising recession risks and the fact that achieving a “soft landing”, while possible, is getting more challenging.
It forecast GDP at 0.5% in 2023 and 1.6% in 2024, down from 1.2% and 1.7% respectively, reflecting increased concerns about a dip into recession in 2023.
The committee raised its inflation forecast from 2.8% to 3.1% for 2023 and from 2.3% to 2.5% in 2024, acknowledging the fact that sticky services inflation sectors are proving stubborn.
Elsewhere it increased its unemployment forecast from 4.4% in 2023 and 2024 to 4.6% for both years, indicating its expectation that tighter monetary policy will lead to a more balanced labor market.
Although we believe a “soft landing” is achievable, it will be a difficult needle to thread for the Fed. Labor market conditions will need to cool enough to temper wage growth, but not too much that aggregate job losses result in a feedback loop that leads to a recession.
Complicating the Fed’s job is the stock of excess consumer savings, which has helped keep consumer spending (and therefore employment) ticking along. Excess savings peaked at ~$2trn in 2021 but are now in the region of ~$800bn to ~$1.2trn by our estimates (Figure 3). The Fed will be conscious of the risks to the growth and employment outlook as these savings are depleted.
Figure 3: The Fed will be watching consumer excess savings closely3
We see rate cuts as unlikely anytime soon as the Fed looks to keep financial conditions tight
At the time of writing, markets are still pricing in rate cuts by the end of 2023, in contrast to the Fed’s new dot plot. We see this as a highly unlikely prospect. The Fed has still not seen any significant success in loosening the labor market across the economy, despite tech sector layoffs dominating the headlines (Figure 4).
Figure 4: A tight labor market makes eventual rate cuts look like a distant prospect4
Therefore, it is difficult to see any justification for policy easing anytime soon, absent a severe and unexpected deterioration in the economy. However, even if the Fed fails to achieve a soft landing, we believe any recession would be relatively shallow.
The Fed is conscious about appearing too dovish, to ensure financial conditions remain tight
We believe Chair Powell and the Fed were keen to send a signal that it is still focused on inflation, and it has further to go to keep it under control.
Even as the data improves, inflation remains a long way from the Fed’s 2% target. Markets taking too optimistic a message from the central bank risks an easing in financial conditions, which would potentially put the Fed’s progress on inflation in jeopardy.
Figure 5: The Fed needs to keep financial conditions tight to keep making progress on inflation5
As such, the Fed will be focused on its market communications, to keep markets aware that it is still focused on doing whatever is necessary to bring inflation down to its 2% target.
Therefore, we believe investors need to be conscious of continuing volatility across fixed income markets as financial conditions remain historically tight.
