The Fed Throws Down The Gauntlet

Scott Anderson
Chief Economist
Bank of the West

The soft landing fairytale that the Fed would be able to bring inflation back down to its 2.0% target without causing measurable economic pain is rapidly evaporating on Wall Street.  Jerome Powell put a nail in that coffin this week during his post FOMC Meeting press conference.   

Powell let it be known very clearly that there will be no easing off the monetary brake pedal until the Fed is convinced inflation is heading back down to their 2.0% target.  The Fed wants to see growth below trend for some time, the U.S. labor market moving back into balance, and inflation moving back down to 2.0%, before they will even think about shifting course.  He was very clear that they think they need to create some slack in the labor market to return it to balance and that the housing market will need to "correct"  to help bring it back into balance. 

Putting it all together, Powell and the Federal Reserve are putting the world on notice that a U.S. recession is quite possible and will be tolerated, if necessary, to bring inflation to heel.  Though he was careful to say that a recession was not the Fed's goal. 

However, it is now our baseline view, i.e. forecast, that the U.S. economy will indeed enter at least a mild recession in 2023, probably sometime in the first half of 2023. We put the probability of a 2023 recession at around 65% today. Peak-to-trough we are forecasting a 0.4% decline in real GDP with the unemployment rate rising to 4.8% by the end of 2023.  A big enough drop in real GDP and increase in unemployment for the U.S. economy to lose a net 1.4 million jobs next year. By historical standards this would still be a mild recession, though we would note that the balance of risks on the U.S. growth outlook remain squarely on the downside as long as the Fed remains in inflation fighting mode. 

The Fed has already raised the Fed funds target rate by 300 basis points since March with three consecutive 75 basis point rate hikes over the last three meetings. The fastest pace of rate hikes from the Fed since the early 1980s. But the big surprise from the September FOMC meeting last Wednesday was how much higher the majority of FOMC participants thought the Fed funds rate must go before they will be able to stop, i.e. the terminal rate for this tightening cycle.

The revised September FOMC Dot-Plot showed a much more aggressive rate hike path from here. The median FOMC participant and now the financial markets expect another super-sized 75 basis point rate hike from the Fed in November and another 50 basis point hike in December to close out the year with a Fed funds target rate of between 4.25 to 4.50 percent. This is 25 basis points higher than our forecast going into the FOMC meeting. In light of the new FOMC guidance, we have moved our forecast for the Fed funds target rate up to 4.375% by year end and now see another 25 basis point rate hike in February to boot. This puts our new terminal Fed funds rate forecast at 4.625%, a full 50 basis points higher than it was a week ago.

After February next year we think the Fed will take a long pause to see the economic and inflationary impacts of their rate hikes to date, but won't be in a position to start cutting interest rates until 2024 at the earliest. In fact, the balance of risks remain more to the upside for further Fed rate hikes in 2023 rather than early rate cuts.

Fed Funds Rate Forecasts Moving Higher Thru 2025

Bottom-line, Powell's message coming out of the September FOMC meeting was we are serious about bringing inflation back down to target sooner rather than later, this is not a bluff, and we are willing to put short-term interest rates where our mouth is. Other major central banks are following suit. Just this week the Swedish central bank hiked their policy rate by 100 basis points, Switzerland hiked by 75 basis points, and the United Kingdom hiked by 50 basis points.

Of course this repricing of the expected Fed funds rate is causing wholesale carnage and repricing all along the Treasury yield curve. Interest rates at all maturities are expected to move higher and stay at those levels longer than previous projections. Global equity markets as you can image are not swallowing the Fed's message well and equity analysts on the street are furiously cutting their year-end price targets. So now is a good time to keep your head down and take some shelter as the Fed is about to start breaking our finest china.

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


[Contributors Section]