Seema Shah
At yesterday’s meeting, for the first time since March 2022, the Federal Reserve (Fed) chose not to raise policy rates, instead keeping the benchmark rate at 5.00%-5.25%. However, the Fed still managed to deliver a hawkish blow to markets. The latest dot plot shows a peak Fed funds rate of 5.6% this year, equivalent to two more 25 basis point hikes.
Fed Chair Jerome Powell emphasised that, while the committee thinks it will be appropriate to raise rates further, considering how far and fast rates have already moved, it would be prudent to slow the pace of hiking. The long and variable lags of monetary policy means that the negative impact on growth is only just starting to unfold. Pausing in June allows them to see more economic data, helping them evaluate how much the economy is slowing and gives them a greater chance at achieving a soft landing. Market analysts, on the other hand, were less convinced, instead questioning whether a pause could simply lead to a further easing in financial conditions and ultimately raise the chances of an inflation resurgence.
Sticky inflation and a tight labor market
Chair Powell repeatedly noted that inflation has proved stickier than they had originally anticipated, and risks are still to the upside. He emphasised that while some segments of core inflation have been easing, core services ex-housing (which is closely tied to wage growth and the tightness of the labor market) is particularly stubborn. Powell did point out that there are a few signs which suggest the labor demand/supply imbalance is starting to ease, but clearly, the labor market remains extremely tight.
Updates to the Summary of Economic Projections
The new dot plot and Summary of Economic Projections (SEP) indicates that the economy is proving more resilient than expected, and the labor market is still extremely strong. With this solid economic backdrop, the FOMC believes further rate hikes are necessary to deliver price stability:
The median projection has rates ending this year at 5.6%. This equates to two more 25 bps hikes this year—above the broad market consensus for only one more hike. By implication, this also indicates rate cuts are still not on the agenda for this year. Indeed, Powell noted that “not a single person on the committee wrote down a rate cut this year.”
9 of the 18 participants believe that policy rates need to rise by 50 bps this year, and three participants see rates rising even more than that—one of whom sees rates above 6% by year-end. In other words, the majority of the FOMC sees at least two more hikes this year.
In 2024, the median dot plot sees rates falling 100 bps to 4.6%. This is also considerably more hawkish than most forecasters had anticipated, and drives home the “higher for longer” theme.
- The median projection then falls to 3.4% in 2025, up from 3.1% in the March dot plot.
- The Summary of Economic Projections also showed some meaningful revisions:
- The core PCE inflation forecast for 2023 was revised slightly higher from 3.6% to 3.9%, while 2024 remained unchanged at 2.6%. Core inflation has been proving very sticky, and yesterday’s CPI reportshowed that monthly core inflation has remained at the same pace since December last year. The FOMC projections see inflation only approaching the 2% target in 2025.
- The unemployment rate forecast for end-2023 was revised lower from 4.5% to 4.1%. This makes sense given the unemployment rate has only risen to 3.7% so far. Importantly, the 2024 unemployment rate projection was left broadly unchanged at 4.5%.
- It’s worth pointing out that the Sahm Rule is still in play. Created by former Fed economist Claudia Sahm, it stipulates that recession occurs when the unemployment rate rises by at least 0.5%. In other words, if the Fed’s own unemployment forecast pans out, it points to recession…
- … and yet, the GDP forecasts for this year were revised higher, from 0.4% to 1.0% for 2023, while the 2024 forecast was left broadly unchanged at 1.1%. Our own forecasts see recession starting in 4Q and lasting two quarters—a fairly modest downturn.
In recent weeks, market consensus had gathered around a June pause, followed by a July hike. While Powell confirmed that July’s meeting is “live,” markets will have been surprised by the additional 25 basis points hike included in today’s median dot plot. For now, however, markets are treating this projection with a grain of salt and have maintained their pricing for rates to peak in July. Over the last two years, the Fed’s own policy rate projections have proved woefully incorrect, continuously falling short of the tightening that has taken place. In that regard, perhaps the market should be concerned about an even more hawkish Fed than even the dot plot suggests.
Our own long-held forecast is for just one more 25 basis points hike, with rates peaking at 5.25%-5.50%, driven by a more negative view of economic growth. While Powell believes there is a path to a soft landing, we believe the very aggressive tightening to date will still take a heavier toll on the economy, and push the U.S. into recession before year-end.
By Seema Shah, Chief Global Strategist