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- Activities are slowing on the margin but not at an alarming rate
- Inflation is easing but likely to remain in uncomfortable territory for a while
- Consequently, the Fed would need to hike enough to slow down the economy in a sustained manner
- In this context, implication for asset prices is gloomy
- Tightening US monetary conditions would exacerbate economic headwinds worldwide
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Commentary: Fed funds rate heading to 4%
A large number of US data releases came through last week, covering manufacturers’ survey, home price, consumer sentiment, jobs, wages, prices, auto sales, factory sales, etc. With a data light week ahead, we think there is sufficient information available to build on Chair Powell’s Jackson Hole remarks and take stock of what is to come from the Fed in the final four months of the year.
Bottom line, activities are slowing on the margin but not at an alarming rate; inflation is easing but likely to remain in uncomfortable territory for a while. It follows from here that implication for asset prices is gloomy, as the above combination would compel the US Federal Reserve keep hiking interest rates.
Since early summer we have been of the view that the underlying inflation pressure on the US economy would push the US Fed to hike its policy rate to 3.5% by the end of the year. This is still a plausible scenario, especially if growth slows sharply in the coming months. The latest dataflow and Fed communication however paint the making of a more hawkish scenario. We are therefore marking up our Fed funds rate forecast to 4% for end-22.
The cues for this scenario span Fed Chair Powell’s Jackson Hole remarks in August in which he accepted the possibility that reducing inflation is likely to require a sustained period of below-trend growth. We no longer think a terminal rate of 3.5% would necessarily keep growth to below trend or bring down inflation expectations sufficiently to comfort the Fed. A more appropriate stance in this context would be a terminal rate of 4%, in our view.
The past week’s dataflow is a useful illustration of the dynamic at play. Manufacturing activity remains comfortably in expansion territory, but easing at a measured pace; declining energy prices have buoyed consumer confidence; job opening figures remain exceptionally strong; jobless claims are back to pre-pandemic levels; non-farm payrolls are strong; input prices are easing but wages and unit labour costs are still rising robustly; house sales are down but house price and rents are still up sharply.
Market implied recession probability, typically extracted from the 2yr-10yr bond yield spread, is around 17% for a 2023 recession, but Nowcasting models show 2%+ growth momentum presently.
Taking these together, we conclude that the Fed’s policy tightening measures have had a sobering impact on the housing market and a wide range of other asset prices, but the rate hikes are yet to translate into softening of wages and rents. Economic slowdown looks likely, but the goal of taking inflation down toward 2% seems only likely in 2024 and beyond, and that too after a prolonged period of tight monetary policy.
What would a prolonged period of tight policy entail? If we consider the gap between Fed Funds rate and core PCE inflation derived from our forecasts, we see real interest rate of around 1¼% by end-2023. That corresponds with a real GDP growth of around 2% at the 4th quarter of 2023.
That nexus, which may well be considered goldilocks, has not been seen in the recent past, with a more typical juxtaposition being substantially negative real rates accompanying 2-3% GDP growth over the past decade.
What if growth slows substantially more next year, let’s say averaging no more than 1%? Would the Fed blink immediately? We think not. Going back to Chair Powell’s assertion that a “sustained” period of below-trend growth may be necessary for inflation to come down to a level in line with the central bank’s objective, we think the Fed would not jump to cut rates next year even if growth tracked 1% all through next year.
But what if growth slowed to zero percent or below? In that case, the Fed would blink, but only if that comes with major asset market unrest and global economic distress. That is not at all out of the realms of possibility, given the plethora of macro and geopolitical risks around the world. For now though, we will leave this scenario in our tail risk box.
Taimur Baig
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