The Fed loses patience with inflation
Dr. David Kelly
For the first time since December 2018, the Federal Open Market Committee (FOMC) voted to raise the Federal funds target rate range by a ¼ percent to 0.25%-0.50% and made it clear further increases would be appropriate to tame inflation.
Notably, the statement effectively replaced the language around COVID-19 threatening the economic outlook with text citing a more immediate concern of Russia’s invasion of Ukraine causing higher prices and softening demand. While escalating geopolitical tensions overseas increase uncertainty, the Federal Reserve (Fed) is clearly positive with regards to the economic outlook, yet uncomfortable with inflation. Elsewhere, the statement noted that the committee plans to reduce the size of its now USD 9.0trillion balance sheet “at a coming meeting”. We believe the committee will announce a path towards balance sheet runoff sooner than initially anticipated, likely at its May meeting, and commence rolling off its assets in May or June.
The Fed delivered hawkish forward guidance by way of its updated summary of economic projections and median “dot” plot. Real GDP was downgraded materially from 4.0% to 2.8% year-over-year (y/y) in the fourth quarter of 2022, partially reflecting Russia’s invasion of Ukraine curtailing economic activity. With that said, its impact is expected to be short-lived as no changes were made to its 2023 and 2024 GDP targets of 2.2% and 2.0%, respectively.
Unsurprisingly, core and headline PCE inflation were revised markedly higher by 1.4% and 1.7% to 4.1% and 4.3% y/y, respectively in 2022, largely reflecting the jump in energy and food prices due to geopolitical tensions, but also broader price pressures persisting in the “stickier” core inflation basket. Interestingly, the committee made no changes to its unemployment rate forecasts, outside a 0.1% increase in 2024. Effectively, committee members view the labor market as incredibly tight, and therefore the primary focus should be to cool inflation to promote a long expansion.
With regards to the outlook on policy rates, the median voting member now expects seven hikes this year, lifting the target range to 1.75-2.00% by year-end, a full percentage point higher relative to its December meeting. Moreover, another four hikes are expected next year, consequently signaling short rates could end this hiking cycle higher than the committee’s long-run projection or perceived neutral rate of 2.4%, a clear indication the committee’s base case is for persistent inflation that may not be quelled until rates are restrictive.
Overall, the Fed’s communication today was very hawkish. Yields lurched higher after the announcement with the 2yr. and 10yr. rates rising 12 bps and 6 bps, respectively. Equities sold off initially, before recovering somewhat. Coming into today’s meeting, however, markets were already pricing in six to seven rates hikes from the Fed this year and financial conditions had already tightened as result. Looking ahead, markets may very well dictate Fed action in the coming months. In other words, what’s palatable for markets, will be delivered by the Fed.