Fed Monitor: Either Inflation Is Too Weak or Growth Is Too Strong

Summary of Key Issues

Current Fed View

The evolution of the SEP end-2023 inflation and unemployment forecasts shows the Fed is much more focused on the employment than on the inflation leg of its mandate (Chart 1).   

My base case scenario is one more 2023 hike in November and three hikes in 2024 starting around mid-year and based on core inflation remaining around 4%. This compares with market pricing of four cuts in 2024 (Chart 2).   

With no growth in banks assets and therefore in reserves demand, QT is likely to continue into 2024, based on a continued decline in the RRP and stable reserves (Charts 4, 5, and 9).

Loose Financial Conditions

Even after the recent increase in long-term yields, financial conditions remain well below the peak of end-October 2022, despite the FFR increasing by 225bp since then (Chart 7). 

The Fed sees the banking crisis as over, though banks’ borrowing from the Bank Term Funding Facility continues growing, if slowly (Chart 8). Overall bank lending has picked up over the summer, though mainly at small banks (Chart 9). 

The Fed’s planned increase in banks’ capital could see banks tighten credit conditions, which I think the Fed would welcome. However, the measure has elicited strong opposition from banks and two of the Board Governors. The Fed could therefore struggle to get it implemented.

Risk Management Suggests One More 2023 Hike

FOMC members have already indicated that they would remain on hold at the September meeting.

I expect the September SEP to show one more hike in 2023. This is because inflation is behaving as expected in the June SEP (i.e., core PCE is on track to end 2023 around 3.9% Q4/Q4 (Table 1).

Furthermore, the combination of slowing core inflation and accelerating growth is inconsistent and is likely to get resolved with either growth slowing or inflation accelerating. Since the Fed does not have a consensus on which is more likely, one additional 2023 rate hike could be a compromise between hawks and doves. Chicago Fed president Goolsbee (voter, dove) commented on 7 September that ‘the Fed was almost done hiking’ (Table 2).

I also expect the September SEP to show fewer rate cuts in 2024 than the four included in the June SEP as well as higher 2023 and 2024 growth. This is because growth has remained higher than implied by the June SEP forecast of Q4/Q4 2023 growth at 1% and because Powell believes that ‘evidence of persistently above trend growth could put further progress on inflation at risk.’

In 2024, I expect core inflation to remain sticky around 4%. As a result, I expect the Fed to resume gradual tightening around mid-2024.

I see the risks to my scenario tilted to the upside by the recent rally in oil prices. A sustainable move of oil prices above $90/barrel could see core PCE accelerate and the Fed reassess its strategy.

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Markets Under-Pricing the Fed

Economic Data Still Calls for More Fed Tightening

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)