The Fed Goes Big In June And Rattles Some Nerves

Scott Anderson
Chief Economist
Bank of the West

Go Big Or Go Home! they say, well the Fed made a last minute decision to "Go Big" at the June FOMC meeting, increasing the Fed funds rate by three-quarters of a percentage point. It was the largest individual rate hike move in 28 years. The Fed seems to have finally lost all patience that the inflation rate will moderate on its own. The catalyst for the FOMC's dramatic move occurred last Friday, only a couple of days before the June FOMC decision, with the release of terrible May CPI and University of Michigan Sentiment reports. We wrote about it extensively in last week's US Outlook Report when we sounded the alarm of Stagflation Or Worse Ahead.

The CPI index jumped 1.0% in May as energy and most other prices surged, up from an April CPI gain of just 0.3% that at that time had the Fed thinking the worst of the inflation problem might be in the rear-view mirror.

Fed Can't Tolerate Inflation Of This Magnitude
At the same time, rising inflationary expectations among consumers and in the bond market was an unwelcome surprise that caught the Fed's full-attention. Together this data helped convince the Fed they needed to do more to fight inflation and show their resolve to stem this inflationary cycle.

LT Inflation Expectations Move In The Wrong Direction
The only way the Fed can fight this price inflation, already at 40 year highs, is to slow demand, and the only tool it can weld is to make it more expensive for consumers and businesses to borrow money. From the consumers perspective this will only add more economic and financial pain to an already fraught economic and financial environment. It will make it more expensive for consumers to finance already expensive motor vehicle and house purchases, or pay off their credit card balances. The goal is that eventual price inflation will ease and the Fed will be able to ease up on the monetary brakes.

It will be many months before we know if the Fed's action this week will have a meaningful impact on price inflation, but we are already seeing the first signs that it is having a negative impact on demand in some areas of the economy, especially housing. Housing starts dropped 14% in May and building permits slumped 7%. The NAHB Housing Market index has been dropping since December and that decline has accelerated over the past two months. Home price deflation is soon to follow.

Moreover, the Fed is also taking a lot of the froth out of the financial markets. Equity valuations got over-extended during the pandemic and we saw wild speculation in cryptocurrencies and NFT's. The era of financial market exuberance is swiftly coming to an end with the Fed's dramatic actions to cool the economy down and bring down hyper-ventilating price pressures. Year-to-date the S&P 500 is down 23%, the NASDAQ is down 32%, and bitcoin is down 66%. If you haven't looked at your 401K balance lately, brace yourself for a shock.

We have had market selloffs like this in the recent past where the Fed has pulled out the stops to come to the rescue for investors, rapidly dropping rates or providing liquidity to ease the pain. In fact, Wall Street coined the phrase Powell "Put" to justify buying the dips and staying fully invested. But this time is different. This market selloff, as long as it stays orderly, is actually part of the Fed's playbook to soften demand and cool inflation. So while the market selloff has already been painful, it could continue for quite a while longer. Investors may have already factored in most of the Fed's future rate hikes in the Treasury yield curve, but probably haven't fully priced in the likely economic fallout from those hikes, or the full impact it will have on future company earnings. Companies may have to face slowing sales and rising costs for some time before they start to see some relief.

Stagflation Or Worse Ahead
Not surprisingly, the economic outlook has deteriorated as a result of this latest inflationary shock from the energy market and the Fed's aggressive response to combat it. In fact, the baseline U.S. forecast is for stagflationary growth through 2023 with elevated downside risks that make a recession twelve months out a very high probability. We put the probability of recession a year out at around 50%. We expect another 75 basis point rate hike from the Fed in July, a 50 basis point hike in September, and 25 basis point hikes at the November and December meetings. The Fed funds target rate is expected to end 2022 in the 3.25 to 3.50% range. For 2023, we are penciling in two more quarter-point rate hikes for February and June with a terminal rate for this rate hike cycle of between 3.75 to 4.0%. We expect two quarter-point rate cuts in 2024 as inflation pressures ease.

Fed To Push Treasury Yields Above 4.0%
Our baseline forecast is for real consumer spending and GDP growth to moderate over the next six quarters. GDP growth by the second half of next year is expected to slump below 1.0% on an annualized basis.

GDP Growth Nears Stall Speed By 2H 2023 Or Sooner
If the market selloff intensifies or becomes disorderly the deceleration in growth could be sharper and the risk of recession could move up to early 2023.

To learn more, check out this week's U.S. Outlook Report.


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