The Federal Reserve on Wednesday laid the groundwork for an eventual pause in interest rate increases early next year, even as it indicated it intends to continue lifting rates into a slowdown.
The Fed laid the groundwork for an eventual pause in interest rate increases early next year.
The projection of a slowdown, which is in the Summary of Economic Projections released after the Federal Open Market Committee meeting, comes as close to the Fed forecasting a recession as one is ever likely to see.
That forecast came after the central bank lifted its policy rate by 50 basis points to a range of 4.25% to 4.5% and forecast a median policy rate of 5.1% next year.
But there is also risk of a higher policy rate if inflation proves more persistent than that implied by the SEP, which expects the core PCE inflation rate to end next year at 3.5%, fall to 2.5% the following year and stand at 2.1% in 2025.
The issue is not so much whether the Fed will pause its rate increases as much as when it will pause them (we think March) and what the peak will be.
How long will the Fed hold rates higher in the face of a slowing economy and elevated inflation?
The policy peak, known as the terminal rate, is going to be at the very least 5.25% with the risk of a much higher rate. That peak will be determined when cost-push inflation and wages are contained and a peak in shelter costs is reached.
Federal Reserve Chairman Jerome Powell, in his news conference after the meeting, was careful to point to his analysis that services inflation—which captures cost-push inflation and wages—will be slow to come down because wage growth is still too high and is feeding into service costs.
Still, the question remains: How long will the Fed hold rates higher next year in the face of a slowing economy and elevated inflation? We expect the Fed to increase its policy rate by 50 basis points when it meets in February and then by 25 basis points when it meets in March. Those increases would result in a policy rate between 5% and 5.25%.
Powell also noted that the central bank is now focusing on a policy stance that is restrictive enough to get inflation back to its 2% target. That would denote some upside risk on our provisional forecast of a 5.25% peak in the policy rate.
At that point, we expect the Fed to pause as it assesses the impact of past policy hikes on the American real economy. The Fed’s lift-and-hold framework will be put to the test as the economy most likely slips into recession next year.
From our vantage point, the key will be how soon shelter costs peak—we think by the middle of next year—and the direction of wages.
The most important point determining whether there are rate cuts next or year or, more likely, in early 2024, will be if wages continue to rise, or if the economy falls off the cliff and requires a monetary response even as inflation remains well above the 2% target.
Summary of Economic Projections
The latest Summary of Economic Projections saw the 2022 growth forecast rise to 0.5% from the 0.2% increase projected in September’s SEP. For next year, the growth forecast was revised down to a 0.5% gain from 1.2% previously.
The unemployment rate forecast for next year was increased to 4.6% and is expected to hold there throughout 2024 and end 2025 at 4.5%, which is in line with the RSM 2022 employment forecast. That forecast would imply a loss of more than 1 million jobs next year from current levels.
The core personal consumption expenditures inflation forecast was increased to 4.8% for this year and revised up to 3.5% for 2023. There were no changes in the forecast for long-term gross domestic product growth (1.8%), the unemployment rate (4%), or the PCE inflation rate (2%).
The dot plot policy rate forecast had 10 of 19 members of the FOMC indicate that the terminal rate for next year should be set at 5.1%. Seventeen of the 19 thought it should be 5% or higher, five thought 5.4% and two had 5.6%.
The rate increase of 50 basis points was only the sixth time in the past 30 years that the central bank had lifted its policy rate by that much following four straight 75 basis-point hikes.
The takeaway
The Fed lifted the terminal rate to 5.1%, which is above market expectations and is the main reason that asset prices deteriorated after the announcement. It would appear that the Fed intends to hike rates by 50 basis points in February, 25 basis points in March and then hold that rate throughout the remainder of next year, which implies that any talk of rate cuts should be postponed until early 2024.
