The Fed’s “summer of 75” closes with another big hike
Persistent inflation has left the Fed with little choice but to continue its recent run of large interest rate hikes. With monetary policy now firmly in restrictive territory, we expect a moderation in inflation … but at the likely cost of weaker job creation and slower growth.
The U.S. Federal Reserve raised its policy rate by 75 basis points (bps) for the third straight meeting, bringing the “summer of 75” to a close and its target rate range to 3.00% - 3.25%. But the Fed isn’t done yet. The Fed’s own forecasts now call for rates to rise to a 4.25% - 4.50% range by December and move a bit higher in 2023.
Coming into the meeting, there was some talk that the Fed could hike by an even larger increment, particularly after core consumer price inflation data for August came in twice as fast as expected. But policymakers opted to keep the pace of hikes constant, perhaps cognizant of markets’ sensitivity to hawkish policy surprises.
The Fed made almost no changes to its statement, describing economic growth as “modest.”
Rate hikes: the irresistible force
Following the Fed’s last meeting in late July, markets had assumed – mistakenly, it turned out – that the pace of rate hikes was about to slow. Two great job reports and a hot August inflation print have dashed those hopes. In the past two months, markets have priced in close to 100 bps of additional policy rate increases by the end of 2022 beyond what was already expected. Coming into this meeting, investors had priced in another 125 bps combined at the final two meetings of the year.
Based on its new forecasts, the Fed seems to share this view. It’s a close call (10 to 9), but the majority of the FOMC expects at least one more 75 bps rate hike, probably in November, followed by a 50 bps move in December and another 25 bps hike in 2023. Rate cuts do not appear in the forecast until 2024 and 2025, though there is a lot of dispersion among members beyond next year.
The cost of these hikes was also apparent in the forecasts. The median GDP growth forecast for 2023 is down to 1.2% from 1.7% in June, and the unemployment rate is expected to rise to a peak of 4.4% from its recent 3.5% low. Inflation is also expected to be more persistent, with the median forecast projecting 3.1% core PCE price index growth in 2023. The Fed’s target remains 2%.
Having staked a claim as an inflation fighter at any cost, Chair Jay Powell will now follow through on this commitment until the rate of price increases slows to something like its 2% target. Fed tightening is exerting an irresistible force on the U.S. economy. Having already brought the housing market to its knees, the Fed now wants to bring the U.S. growth rate below its 1.8% trend, which should discourage companies from hiring new workers. Lowering income and spending growth is now the Fed’s only way to reduce inflation over the next 12 months.
Consumers: the immovable objects
On its mission to cool the economy, the Fed has run into a significant obstacle: U.S. consumers have thus far refused to reduce their spending from the overstimulated days of 2021. Indeed, the rate of household spending growth even in excess of inflation has remained solidly positive this year. How is this possible with inflation rising at close to a double-digit annualized pace?
A variety of factors have helped bolster U.S. consumers. First, households still have trillions in excess savings from the pandemic and the related stimulus programs. Second, household debt service costs are still close to all-time low levels thanks to the legacy of low interest rates over the past decade until this year. Third, falling gasoline prices have helped real income growth turn positive for the first time in a year. Last, job security is still unusually high, arming consumers with the confidence to spend more and save less.
In the near term, the Fed has the best chance at affecting the last of these. Debt service costs are slow to rise even when policy rates are moving up quickly. Most homeowners are paying off their mortgages at extremely low rates. Credit card balances are increasing but remain below their pre-pandemic trend, as consumers paid down debt during the first year of the pandemic. But by softening the labor market, the Fed can strike at the hidden heart of consumer confidence: workers’ conviction that they are unlikely to lose their jobs and could find other gainful employment quickly.
Whether the immovable object starts to budge in the closing months of the year will depend in large part on whether the monthly job reports show any signs of weakening. The recent surprising downward trend in unemployment claims indicates that we may have to wait at least a few more months.
Markets stuck in between
Investors have had a rough ride in this intermeeting period, with upside inflation surprises and hawkish central bank rhetoric spoiling falling gasoline prices and strong hiring. The S&P 500 Index is still up more than 5% from its June low, but it resides nearly 20% below its January high. With rates still rising to a terminus of uncertain altitude, we’re concerned stocks may retest their lows before they reclaim their highs.
Earnings estimates for both 2022 and 2023 have been surprisingly durable in the face of rising rates. Equity markets seem to have priced in higher discount rates but have not priced in the negative effect higher rates could have on economic and financial fundamentals. Because earnings remain vulnerable to downgrades if consumer spending softens, we prefer for now to move up the capital structure and focus on credit.
While the macro outlook is uncertain, we think the U.S. economy can avoid a severe recession that would trigger a rise in corporate defaults. Absent that deterioration in credit markets, valuations are attractive, particularly for investors focused on increasing the yield in their portfolios. This is even truer in municipal markets, where balance sheets are in very strong shape but the abrupt rise in rates has caused munis to sell off disproportionately.
Investors do not have a lot of obvious places to turn for high risk-adjusted returns in these uncertain times. But the across-the-board drop in financial asset prices presents opportunities, especially in fixed income markets where interest rates have finally returned to their historical average level of yield, compensating investors for the risks that still lie ahead.
Federal Reserve Statement, September 2022.
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