Hawkish moves and hawkish guidance
The Federal Open Market Committee (FOMC) voted unanimously to raise the Federal funds rate target range by 0.75% to 3.00%-3.25%. The tone of the committee remains hawkish given policymakers are “highly attentive” to taming inflation that runs well above its 2% target. Strong job growth and persistent excess demand for labor suggest a soft landing is still possible. However, aggressive Federal Reserve (Fed) tightening keeps the probability of recession sometime next year elevated.
The committee delivered forward guidance through its Summary of Economic Projections (SEP) and provided a much more hawkish median “dot” plot. Relative to their June forecasts:
- The FOMC sees the federal funds rate ending 2022 at 4.4% and hitting a 4.6% terminal rate in 2023, with rates remaining restrictive until at least 2025.
- Real GDP growth projections were revised lower from 1.7% year-over-year in 4Q22 to just 0.2%, and cut to 1.2% by 4Q23, followed by a more sustainable 1.5%-2.0% through 2025.
- Expectations for year-over-year personal consumption expenditures deflator inflation for 4Q22 were revised higher with headline up to 5.4% from 5.2% and core up to 4.5% from 4.3%. Thereafter, inflation is still expected to cool steadily through 2025.
- The 4Q22 unemployment rate forecast was nudged up to 3.8% compared to 3.7% in June. 2023 and 2024 forecasts saw more significant boosts to 4.4% in each year from 3.9% and 4.1% respectively.
In our view, the key messages from the updated SEP and dot plot are:
- Sticky inflationary pressures in owners’ equivalent rent, rental Consumer Price Index (CPI) and wage growth will keep core inflation stubbornly elevated into next year, while declines in energy and U.S. gasoline prices should lead to a larger decline in headline consumer prices.
- The slide seen in both real GDP and productivity in the first half of the year do not reflect an economy in recession. That said, the committee recognizes that businesses and consumers will come under pressure as the economy enters a period of higher rates.
- The persistent excess demand for labor is expected to the keep the rise in the unemployment rate modest, but higher unemployment is a necessary evil to kill inflation.
- The committee will lift rates to 4-5% next year and doesn’t expect to begin lowering rates until 2025.
The statement language was nearly identical to July and notably reiterated that “ongoing increases in the target range will be appropriate”, keeping the door open for another 125 bps in increases by year end.
At the press conference, Fed Chairman Jerome Powell repeated his Jackson Hole messaging, noting that restoring price stability will keep rates restrictive for “some time”, but at some point, a slower pace of rate hikes “will become appropriate”. For now, the FOMC remains laser focused on inflation and keeping inflation expectations anchored. Interestingly, Powell never made use of the word recession, but did acknowledge that there will likely be a period of “sustained period of below-trend growth”. When asked about cutting rates, Powell stated that the FOMC would need to see below-trend growth, a more balanced labor market and clear evidence that inflation is heading back towards its 2% target before considering such a move. This is not expected to come soon as Powell stated we are just entering the “lowest level” of restrictive territory. In addition, little mention of the balance sheet runoff suggests the committee will maintain its current pace of quantitative tightening for now. For investors, since the August CPI report, rates have adjusted higher, reflecting the more hawkish path for rates. Given this, the short-term outlook for equities remains challenging while high-quality intermediate to long duration core bonds may be the most attractive sectors within fixed income.