The outlook laid out by the Fed is perplexing and the market isn’t buying what the Fed is selling.
As widely anticipated, the Federal Open Market Committee (FOMC) voted unanimously to raise the federal funds rate target range by 0.50% to 4.25%-4.50% at its December meeting.
The committee delivered hawkish forward guidance through its Summary of Economic Projections (SEP) and median “dot” plot. Relative to their September forecasts:
- The FOMC sees the federal funds rate ending 2023 at 5.1%, a half-percent higher than their September forecast before reducing rates more aggressively in 2024.
- Real GDP growth projections were lowered to 0.5% and 1.6% year-over-year in 4Q23 and 4Q24, respectively.
- Expectations for the year-over-year headline and core PCE deflator were nudged higher for 4Q23 to 3.1% and 3.5%, respectively, before trending to 2.1% by 2025.
- The unemployment rate forecast rose to 4.6% in 2023 and 2024 compared to 4.4% in September.
In our view, the key messages from the updated SEP and dot plot are:
- The range of fed funds estimates for 2023 is quite narrow with only two members seeing policy rates below 5% next year. This suggests a higher terminal rate at or above 5% will be reached in 1H23.
- The committee is all but cementing a need for below-trend growth and a pickup in unemployment to tackle inflation and bring the labor market back into balance. That said, the persistent excess demand for labor could keep the rise in the unemployment rate modest.
0.50%
How much we expect the Federal Reserve to raise rates in early February.
0.25%
How much we expect the Federal Reserve to raise rates on March 22.
We now expect the Federal Reserve to raise rates by 0.50% in early February and by 0.25% on March 22 before pausing, though a shift down in the size of rate increases as signaled in the press conference could see the Fed raise rates in 25 basis point increments over the first three meetings of the year.
The outlook laid out by the Fed is perplexing and the market isn’t buying what the Fed is selling. Although the Fed has signaled rates will be higher and remain restrictive for a period, markets now anticipate a lower terminal rate and 0.50% of rate cuts in the second half of next year. More rate increases than necessary when inflation is showing signs of improving, narrows the runway for a soft landing and current market pricing suggest the Fed may be unsuccessful in orchestrating a soft landing.