Fed to stay aggressive on inflation

The Federal Reserve turned in a much more hawkish than expected September FOMC meeting. The Fed hiked the Federal Funds rate by 75bps to 3.25% on the upper bound, as had been expected by markets given the pace of commentary from Fed speakers in the run-up to the meeting. They will also continue to run down the balance sheet at the now more elevated pace as the FOMC is “strongly committed” to getting inflation to the Fed’s 2% target.

The FOMC was also much more downbeat on the economic outlook with the Fed now expecting unemployment to rise from the current 3.7% to 3.8% next quarter and 4.4% by end of next year. GDP growth is expected to slow to 0.2% this year and 1.2% in 2023, and while a recession has not been explicitly forecast, the forecast rise in unemployment and the refusal to rule it out means that it is far from off the table.

An even more hawkish signal came from the dots plot where the FOMC now projects the Fed Funds rate at 4.4% for the end of the year which would mean another 125bps in hikes from September, slightly faster than what we had previously pencilled in. Markets look to be pricing in another 75bps hike in November followed by a 50bps hike in December to get to the Fed’s projected level though there is a risk of the FOMC choosing to move by 100bps and 25bps. For 2023, the median projection for the Fed Funds rate has also moved considerably higher, to 4.6% from 3.8% as of June. Markets now seem to be taking the Fed as more credible with futures markets matching the Fed as to where they see a peak in rates mid-way through 2023 at around 4.6-4.7%.

Overall the tone from Fed chair Jerome Powell was hawkish and seemed to indicate a recession was likely, saying that “the chances of a soft landing are likely to diminish” and that policy “needs to be restrictive, or restrictive for longer.” More ominously, the chair cautioned that he wished “there were a painless way” to restoring price stability before noting that “there isn’t.” Given the messaging from other Fed speakers this would suggest to us that they are prepared to accept a recession, including one that may be painful in the labour market, in order to get inflation under control and that any early pivot assumptions will be misguided.

To be fair, data in the US has a long way to go before it turns bad. Job growth is still elevated and PMI indicators, while slowing, remain relatively robust compared with the UK or Eurozone economies for instance. Inflation notwithstanding, the economy appears in good shape. Nevertheless, Powell indicated that there was no certainty on “how significant that recession would be” and the aggressive tightening of monetary policy will provide a harsh jolt.

We think there is now more credibility in the Fed sticking to its projections for the Fed Funds rate, at least for this year, and expect they will follow through with the additional 125bps of hikes before the end of 2022, bringing the Fed Funds rate up to 4.5%. For 2023, we still anticipate the Fed will want to maintain policy at a restrictive stance and expect one more 25bps hike in H1 2023, bringing the policy rate up to 4.75% after which we think they will hold for some time before easing back likely only later in the year.