United States
The Fed announced a third consecutive 75bp rate hike, bringing the fed funds rate to 3% to 3.25% and continued to set a hawkish tone, raising its “dot plot” and inflation forecasts, while reducing its growth and unemployment outlook.
We believe investors need to be prepared for a period of higher rates for longer as inflation makes its slow journey back to the Fed’s target. We see recession risks as still finely balanced, and believe credit investors need to be diligent, cautious and ready for volatility.
The new “dot-plot” implies no rate cuts next year
The Fed raised its “dot plot” projections for future rates again (Figure 1). It now projects policy rates at 4.375% by year-end (up 88bp from the projection in June and 188bp higher than in March).
Figure 1: The Fed once again raises its future rate forecasts1
This implies another 125bp of hikes yet for the rest of the year, perhaps 75bp hike at the next meeting in November and another 50bp in December.
Contrary to market pricing, the Fed projects no rate cuts next year (in line with our view). Rate cuts are only implied by 2024, but only as far as 3.875% from 4.625% in 2025, suggesting higher rates for longer.
The Fed is hyper-focused on inflation at the expense of growth
The Fed now projects PCE inflation at 5.4% by year-end (up from its 5.2% projection in June). It also expects core PCE to remain above the 2% target through 2025.
Given the impact of its rate hikes, the Fed materially cut its growth forecasts for 2022 and 2023 to 0.2% and 1.2% from 1.7% and 1.7%, respectively. It also projects unemployment will rise to 4.4% by the end of next year from 3.7% today.
After two decades of being hyper-focused on its growth mandate (at the expense of inflation risks), the tables are turned, with the Fed now pursuing inflation at the expense of growth.
This is reflected by the so-called “misery index,” which adds CPI to the unemployment rate. It is currently as high as it was during the 2008 recession. However, the composition was very different in 2008, as was mostly driven by high unemployment, unlike today, where inflation is the dominant element (Figure 2). Powell stated the Fed is “strongly committed” to restoring 2% inflation and the “economy does not work” without price stability.
Figure 2: The “Misery Index” is at 2008 levels but inflation, not growth, is the problem2
The Fed is making progress, so rate hikes will likely slow into 2023
At its previous meeting, we commented that the Fed’s “game plan” was to start slowing the pace of hikes. However, as hinted at Jackson Hole last month, inflation has been too persistent, now thanks to “sticky” services categories like rents and healthcare (Figure 3). We believe the Fed will need to see Core CPI begin to roll over before feeling comfortable that its policy is working. This has yet to occur, and given the transmission lag of monetary policy changes, it may take some time.
Figure 3: Core CPI is still anchored above 6%, leaving the Fed a long way to go3
Nonetheless, we do expect the Fed will soon slow down its pace of hikes into 2023. Rates are now above the Fed’s estimate of “neutral”, implying smaller hikes will have a bigger impact. The Fed is now quickly catching up to the “Taylor Rule”-implied policy rate (Figure 4) and is on track to surpass it this year. Further, headline inflation is at least now decelerating.
Figure 4: The Fed’s policy is catching up to the Taylor Rule4
The more hawkish the Fed gets, the more careful investors need to be
Last meeting, Fed Chair Jay Powell called a 75bp hike “unusually large,” but these unusual economic times have made them more normal.
This is certainly new territory for this generation of investors. Given a four-decade trend of falling rates on a secular basis, this hike raised the Fed Funds rate above its peak from its previous hiking cycle (in December 2018). This the first time this has happened since 2000 (where rates rose slightly more than they did in the mid-90s). However, it is clear the Fed is not done.
The more hawkish the Fed gets, the more market volatility is likely to be elevated, and the risk of a recession ticks higher. We expect this to keep the Treasury yield curve inverted, which is why we forecast a 10-year yield of 3.6% in a year’s time. Until there is more tangible progress on the inflation front, credit investors need to stay cautious and ensure robust security selection.
