It ain’t over ‘til it’s over
Despite growing political pressure and a deterioration in some leading economic indicators, we expect the Federal Reserve will announce another 75 bp increase in the Fed funds rate this week and leave its quantitative tightening programme unchanged despite growing liquidity worries in the US Treasuries market.
With core consumer inflation still at a lofty annual rate of 6.6% in September and proving to be sticky, we believe the Fed will continue to prioritise inflation fighting. The stubbornness of consumers’ inflation expectations is a particular worry for the Fed. This is why we think Powell is unlikely to commit to an end to Fed tightening for now. The Fed is also paying particular attention to monthly employment gains, which are proving resilient.
The sharp deterioration in the US housing market is unlikely to be central to the Fed’s deliberations, as some Fed members believe housing needs some deflating after the post-covid boom. And the slowdown in housing could have the welcome effect of cooling rental inflation, a major factor in recent price rises in the US.
Money markets are currently pricing in a peak at almost 5% (4.95% to be precise) for the Fed funds rate by May 2023— well above the terminal rate of 4.6% indicated by the Fed in September.
The Fed’s new rate projections will be released at the Federal Open Market Committee meeting on December 14th (our own 2023 scenario for Fed policy is currently being finalised).
Overall, we think it illusory to believe that Powell will signal a near-term end to tightening. He could hint at a slower pace of rate hikes but nothing beyond that in light of recent inflation data.
The risk of a policy mistake (i.e. the risk of over-tightening), is high, especially in an environment of high debt and shrinking market liquidity. We worry about the long lags in monetary policy’s impact on growth: The Fed’s chances of achieving a soft landing in 2023 are narrowing given the sharp tightening that has already occurred, with more still to come.