As heavily signalled over the last couple of days, last week's CPI report was enough for the Fed to hike rates by 75bp instead of 50bp, the largest move since 1994, to 1.5-1.75%.
We believe a sharper hiking cycle will help the Fed from falling far behind the curve, but risks of a hard landing are modestly higher. Although we see opportunities for fixed income investors, continued volatility is inevitable, and so investing requires diligence and care.
Inflation is now an urgent priority for the Fed
Chairman Jay Powell used his press conference to reinforce the Fed’s focus on inflation and its intention to adjust policy in line with data releases. At present, inflation is controlling Fed policy rather than vice versa.
The new “dot plot” was revised sharply higher, with the median projection approaching 4% for end-2023, from less than 3% at the previous meeting (Figure 1).
Figure 1: The Fed’s “dot plot” shows future rate expectations move sharply higher again1
As such, we see another 75bp hike in July is very much in-the-cards, and we also currently expect 50bp in September. We see hikes at every meeting thereafter into mid-2023 as likely, generally at 25bp in magnitude, taking rates up to ~3.75%, around the Fed’s current projection for terminal rates.
The Fed also raised its inflation forecast to 5.2% from 4.3% for end-2022, but slightly lowered its end-2023 forecast to 2.6% from 2.7%, implying above-target inflation to persist beyond the next 18 months, in line with our own views. Its GDP forecast is 1.7% for each of the next two years, down from 2.8% and 2.2%, indicating that it does expect its policy to slow growth.
The Fed is catching up to Taylor Rule-implied policy rates
Last month we discussed how the Fed has been tightening more slowly than the optimal policy rate implied by the Taylor Rule. However, with its latest hike, the Fed is now making up ground (Figure 2).
Figure 2: Fed policy is now catching up to optimal policy rates as implied by the Taylor Rule2
We expect the Fed’s policy to converge to Taylor Rule-implied policy rates by early 2023, assuming its inflation projections broadly play out. The Fed may even overshoot it as it attempts to restrain growth.
Targeting the prized “soft landing”
The Fed’s greatest challenge is to slow growth but avoid a recession – the much vaunted “soft landing”.
The good news is that pandemic-era fiscal stimulus has pushed Gross Domestic Income (a slightly different measure to GDP measuring income-related metrics) ~1.5% above the pre-pandemic trend (Figure 3).
Figure 3: Gross domestic income running above the pre-pandemic trend may be a source of inflation3
As such, if the Fed engineers two years of ~1% growth, it would bring GDI back to trend – implying a successful soft landing. We believe a Fed funds rate in the 3.5-4% area, or about 1% above “neutral”, would providing sufficient tightening.
Recession risks have modestly increased
The primary risk, however, is that abrupt tightening, and negative disposable incomes and financial market headwinds could create feedback effects that slow economic activity further.
“Overtightening” is also a risk, as it takes time for the Fed policy changes to take effect, making it tough to judge when it goes a rate hike too far. Larger hikes carry the greater risk of a more damaging overshoot.
Therefore, we now see the odds of recession in the next 18 months at close to 50:50.
Volatility is inevitable as markets adjust to rising rates
As we discuss soft and hard landings and 1980s-like inflation, it is only fitting that a sequel to Top Gun is dominating the box office. Landing the economy may actually be harder than landing a fighter jet, but we believe a soft landing is still possible as federal fiscal stimulus fades and strong corporate and consumer balance sheets offer a potential airbag.
However, volatility is likely to remain quite high given the uncertainties, so the ride will be turbulent. Although we see opportunities to enter credit markets, care, diligence and rigorous security selection will be increasingly essential.