FOMC Preview: Still Dreaming of a Soft Landing

Summary

• A 75bp hike is likely at the FOMC meeting on 20-21 September.
• The Fed will still communicate a soft landing is possible.
• Having ended forward guidance, it could scrap the dot plot.

Market Implications

• Limited impact since 75bp is priced in.
• If the Fed ends the dot plot (not my base case), market reaction is likely to be negative.

The Market Has Finally Woken Up

After August inflation came in surprisingly high at 8.3%, markets have finally caught on: the Fed has a major problem on its hands, and hiking the federal funds rate (FFR) harder for longer is the only solution (Chart 1).

Markets now expect the Fed will hike interest rates 175bp by the end of the year in a bid to tighten financial conditions and suppress demand. Specifically, they are pricing a 75bp hike at the upcoming FOMC meeting on 20-21 September, then a slight easing to 50bp in both November and December.

This has been my view since the July meeting. Here is why:

1. Economic growth is still too strong. The Fed wants growth below trend in H2. As Chair Jerome Powell explained, the current Fed focus is bringing ‘demand and supply into better balance’. Since the Fed has limited impact on the supply side of the economy, Powell explained, this is ‘likely to require a sustained period of below trend growth’.

2. The labour market is still too tight. As, for example, Fed Governor Christopher Waller stressed, the labour market is still too strong for inflation to return to target, and there are signs of a rebound in consumption.

3. The doves will oppose a 1% hike in September. They will likely argue the federal funds rate (FFR) is already at neutral and, because of the variable lags in monetary policy transmission, the Fed must proceed cautiously to avoid overtightening. This makes a 1% hike unlikely.

Changing Tactics

Unlike previous meetings when the Fed telegraphed its decision beforehand, this time the Fed has given up on forward guidance. The past three weeks saw policy speeches from Powell, Waller, and Vice Chair Lael Brainard; none provided much guidance on next week’s hike. 

Waller also titled his speech ‘Time to Let the Data Do the Talking’ and stated that ‘forward guidance is becoming less useful at this stage of the tightening cycle’. 

A week ago, Cleveland Fed President Loretta Mester explained, ‘we want to convey our reaction function so that people know how we are likely to react, conditional on the economy moving in one way or the other, even though we don’t necessarily know exactly how the economy is going to move.’

How credible is this abandonment of forward guidance? We cannot know until the Fed gets tested, i.e., the market prices in an outcome different from what the Fed wishes. This does not seem to be the case this time, though, as the market is pricing 85bp.

If the Fed abandons forward guidance, it could stop publishing its dot plot: the chart recording Fed officials’ projections for the path of interest rate hikes. I think there is a nearly 50% chance the Fed scraps the dot plot, which would likely see a negative market reaction.

What If the Fed Keeps the Dot Plot?

Following the August inflation print, markets are now pricing a peak policy rate of 4.4% in March 2023, compared with 3.8% beforehand. They then expect the Fed to cut interest rates: the December 2023 Fed funds futures contract is pricing an FFR of around 3.9%. (Our Explainer reveals how all this pricing works.)

If the FOMC’s dot plot shows a peak rate well below the market’s pricing, it risks further undermining its credibility. This could lead to the market pricing deeper rate cuts in 2023 or even an easing of financial conditions.

And that is the last thing the Fed wants. The Fed believes policy tightening gets transmitted through financial conditions. So it wants to avoid easing conditions as inflation is rebounding and growth remains strong.   

Therefore, I expect the 2023 dot to be lifted near current market pricing: for example, 4.3%, from 3.8% in the June SEP.

The Fed Is Still Hoping for a Soft Landing

The Fed will likely stick to its soft-landing scenario. That is no significant increase in unemployment and a smooth easing of inflation over the projection period. Under the Fed’s soft-landing scenario, policy tightening would not last beyond 2023.

However, we have just witnessed in July another iteration of the by-now familiar movie: the Fed intends to stick to its soft-landing scenario, the inflation data comes out stronger than expected, the market reprices the Fed, and the Fed has no choice but to follow the market.

This is unlikely to be the last iteration. I still strongly believe that the Fed will ultimately need to hike interest rates to 8% – and that a hard landing is likely in the second half of 2023.

Market Consequences

The 75bp I have been expecting has now been priced in. The risk to the market therefore comes from the Fed ending the dot plot. That is not my base case, but it is possible.