Fed starts its fight against inflation

The Federal Reserve raised the Fed Funds target rate by 25bps on the upper bound to 0.5%, their first rate hike since the end of 2018. Along with higher rates, the Fed outlined new economic projections where they lowered their economic growth forecast to 2.8% this year from 4.0% previously but kept their unemployment rate forecast at 3.5% unchanged. Inflation is now expected to widely surpass the Fed’s 2% target with PCE inflation forecast at 4.3% this year before moderating over the next several years.

According to the dots plot, the median Fed Funds rate will rise to 1.9% in 2022 which would imply six more 25bps hikes, one at each of the remaining FOMC meetings later this year. However, Fed chair Jerome Powell has still not ruled out moving at a faster pace, perhaps by a 50bps hike at one of the meetings, in order to address the inflation pressures weighing on the US economy. For 2023, the Fed Funds rate is projected at a median of 2.8%, meaning another four 25bps hikes next year.

There is a wide range for rates projections both for this year and next with the 2022 outlook showing 1.4% at the bottom end and more than 3% at the top while in 2023 the range extends from 2.1% to 3.6%. The divergence in views suggests that the Fed’s outlook on inflation and the appropriate policy response is not strongly unified: indeed, St. Louis Fed president James Bullard dissented from the FOMC rate decision in wanting a 50bps hike at this meeting. Markets will likely oscillate in coming weeks as policymakers provide their relatively hawkish or dovish views in commentary against a backdrop of still historically high inflation and the geopolitical crisis in Eastern Europe. However, the Fed is at least now roughly aligned with markets on the trajectory for monetary policy this year with swaps markets also pricing in six additional hikes from now on until the end of the year.

The Fed’s statement gave a modest hint at balance sheet reduction, saying it “expects to begin reducing its holdings” of US treasuries and other securities at a “coming meeting” but with no commitment on the level or pace of unwinding its balance sheet. According to Powell’s press conference after the rate hike announcement, more discussion of the balance sheet rundown process will be available when the Fed releases its minutes of this decision. However, Powell did say it would be at a more rapid pace than previous phases of unwinding its balance sheet.

The risks of the Federal Reserve tipping the US economy into a hard landing appear high with the aggressive hiking path that the Fed has now outlined. The Fed’s own growth projections are considerably below consensus forecasts—with growth of 3.6% expected in 2022—and market indicators are signalling a pending recession. The 2s10s curve has narrowed to little more than 20bps and with inflation pressures unlikely to dissipate soon, the risk of the curve inverting appears high. A salient risk is that of stagflation—low or no growth and high inflation. Beyond seriously slowing demand via rate hikes, tighter US monetary policy will do little to address higher commodity prices, the volatile near-term causes of inflation.