The Fed Hiked Rates to 14-Year Highs & Projected More Moves Ahead; Soft Landing an Illusion?

Historic Hike Due to Inflation

The US Federal Reserve raised interest rates by another 75 basis points on Wednesday ^[1], marking the fifth consecutive move and third straight of that size. It has delivered a massive 300 basis points worth of hikes since the March lift-off, in what is the most aggressive tightening cycle in at least three decades, surpassing the 2.5% upward adjustment of 1994.

Federal fund rates now stand at 3.00%-3.25% and the highest range since January 2008. This also marks a shift from neutral to restrictive territory – which seemed to be the word of the day, as it was mentioned multiple times . Chair Powell said that rates moved "into the very lowest level of what might be restrictive". ^[2]

Officials opted for this historic move, as recent Inflation data did not leave much room for underwhelming action, although going into the meeting there were some expectation of an even bigger move.

The latest inflation report from earlier in the month, showed core Consumer Price Index (CPI) jumped 6.3% year-over-year in August, to the highest print since March, shattering hopes for peak inflation.

More Tightening Ahead

The Fed has stopped offering forward guidance and did not steer away from that with yesterday's policy statement, which was little changed from the previous one. Mr Powell stayed on the same path during his press conference, but the overall messaging was clearly hawkish and the commitment to bring inflation down beyond any doubt.

The Fed Chair did repeat that a slower pace of increase may be required at some point, but reiterated that more hikes will be "appropriate" and that rates will need to remain elevated. He succinctly stated that "restoring price stability will likely require maintaining a restrictive policy stance for some time'.

He also noted that his main message has not changed from his Jackson Hole speech, which we found unusually short and to-the-point, since the FOMC "is strongly resolved to bring inflation down to 2% and we will keep at it until the job is done".

Upgraded Dot-Plot & Market Pricing

The central bank's hawkishness and commitment to front-loaded action in order to restore price stability, was evident in the updated staff economic projections and the new appropriate policy path.

The previous forecasts from June, saw median rates at 3.4% by the end of the year, which seemed reasonable at the time, but is detached from current reality. Officials upgraded their 2022 forecasts aggressively yesterday, to 4.4%, implying 100-125 basis points worth of hikes in the two remaining policy meetings. ^[3]

Moreover, what we would call the terminal rate, is projected a little higher at 4.6% in 2023, from 3.8% in June. Interest rates are projected to ease to 3.9% in 2024 (from 3.4% previously), while the newly introduced forecast for 2025 sees them 2.9%.

It is also worth noting that after this truly massive adjustment in the dot-plot, only one member sees rates below 4% this year and the next, while all participants expects them to stay below 5% throughout the projected period.

Chart Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20220921.pdf

These forecasts don't constitute official policy and there is no guarantee that they will materialize, but updated figures are more in line with the Fed's renewed hawkishness and current market pricing.

At the time of writing, CME's Fed Watch Tool projects rates at 4.5% by the end of the year with 67% probability and going as high as 4.75% in 2023. ^[4]

Soft Landing an Ilusion?

The US economy has posted two consecutive quarters of contraction, but Fed officials have largely dismissed recession fears, pointing mainly to the strong labor market, which has remained "extremely tight"

Based on yesterday's projection, 2022 GDP was downgraded to just 0.2% (from 1.7% previously) and to 1.2% fir 2023 (from 1.9%). Furthermore, the Unemployment Rate is now seen peaking at 4.4% over the next two years, whereas Core PCE Inflation is not expected to hit the 2% target within the projected period (2025).

The central bank appeared to believe that it could restore price stability and achieve a soft landing, ie not causing another surge in Unemployment and not plunging the economy into recession, although we had never found its rhetoric particularly convincing.

At the previous press conference in July, Mr Powell had acknowledged that this path "has clearly narrowed" ^[5], and the "soft landing" reference was interestingly missing from more recent speeches, such as the one at Jackson Hole.

When asked about it yesterday, Chair Powell went a step further, admitting that a soft landing would be "very challenging" and no one knows if the current tightening "will lead to a recession and if so how significant that recession would be". More to it, he emphatically stated that "we have got to get inflation behind as. I wish there was a painless way to do it. There isn't"

Looks like the Fed has conceded to the possibility of a recession and higher unemployment, in its revitalized pursuit to bring inflation down and avoid a de-anchoring of expectations. Of course, priorities change and we don't how officials will react if unemployment starts becoming a problem.

Market Reaction

The Fed delivered a historic rate hike, while signaling more moves ahead to what was a clear hawkish outcome. As such, the US Dollar strengthened after the decision, whereas Wall Street and the bond market suffered, even though there was some two-way action during the press conference.

EUR/USD hit twenty year lows and NAS100 shed more than 2% on Wednesday, although both stage a recovery today.