Monetary Policy & Inflation | US
Summary
- A 50bp hike of the Fed’s policy rate seems highly likely at Wednesday’s FOMC meeting.
- The move would be a deceleration from the four previous 75bp hikes and mark a shift in the Fed’s stance towards inflation.
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Summary
- A 50bp hike of the Fed’s policy rate seems highly likely at Wednesday’s FOMC meeting.
- The move would be a deceleration from the four previous 75bp hikes and mark a shift in the Fed’s stance towards inflation.
- In the Summary of Economic Projections, I expect the forecasted peak in the policy rate to rise from 4.6% to 5.4%.
Market Implications
- The market underestimates the peak rate and has deeply unrealistic expectations of rate cuts in 2023.
What Happens in December Will Define 2023
Hopes and dreams for 2023 seem to hang on the upcoming Fed interest rate decision and policy forecast on Wednesday. Having already hiked a jumbo 75 basis points four times in a row, markets are positioned for a deceleration to 50bp, and we are inclined to agree.
But what about the peak? After all, that’s the real question right now. How high will interest rates get? The Fed produces the Summary of Economic Projections (SEP) at this meeting, where (as in the name) they make projections.
- Chair Jerome Powell hinted the peak would be revised higher.
- I see an increase from 4.6% to 5.4%.
- But markets, optimistic as ever, imply a peak below 5%. (The rate is already at 3.75-4.00%…)
What is the data doing? November’s strong labour market data, with 263,000 jobs added against expectations of 200,000 only, adds fuel to the hawkish fire. Meanwhile, wage inflation remained at 6.4% in November, the same as October, so those pressures are going nowhere.
Walk the talk? Despite easing to 50bp steps, I expect Powell’s inflation-fighting proclamations to remain as strong as ever. Yet the proof of the pudding will be in the eating. All we will be able to observe is inflation prints and the Fed’s reaction to them. We will only find out ex-post if the Fed’s reaction has been adequate.
Meanwhile, financial conditions have been easing. In fact, they are easier now than before September when the rate was 150 basis points lower!(Chart 1)That’s the opposite of what the Fed is trying to do with the hiking…How Powell reacts to this will be important to watch. Powell may not be so aggressive, possibly out of concerns over a disruption of the housing market. If so, it would also increase my doubts on the Fed inflation fighting intentions.
Chart 1: Financial Conditions Ease Despite Hikes
We still believe market consensus underestimates the terminal Fed funds rate (FFR). And even with the pace of hikes likely slowing to 50bp in December, we continue to expect a terminal rate closer to 8%. A strong reason for that is my simplistic Taylor rule, based on median price PCE and the CBO estimate of U*. It remains around 8%, which suggests the economy is tracking roughly as I expect (Chart 2).
Chart 2: The Taylor Rule FFR Has Not Dropped From c.8%
Market Consequences
The market is under-pricing the FFR trajectory. In addition to under-pricing the terminal FFR at a tad below 5% in May 2023, markets have completely unrealistic expectations of Fed rate cuts.
The last time core PCE was at 5% was in 1983. It took more than 10 years for inflation to fall to 2% and for the FFR to fall from 9% to 5.75% (Chart 3). It may not take 10 years this time, but it sure will not take six months either.
Chart 3: Past Fed Cycle Suggest Immediate Rate Cuts Highly Unlikely