Policy normalization at the Federal Reserve took a giant step forward on Wednesday as the Federal Open Market Committee hiked the federal funds rate by 25 basis points to between 25 and 50 basis points while slashing its growth forecast and increasing its estimate of inflation.
The Fed made clear it has no intention to permit inflation expectations from becoming unanchored.
The announcement marks the beginning of a period over the next three years in which FOMC meetings will largely be a function of rate hikes, balance sheet reduction, revising down forecasts, repeat.
While the Fed focused on the conventional portion of its policy normalization strategy, its statement included an important new sentence: “In addition, the committee expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting.”
That statement indicates that the Fed at one of its next two meetings will outline the pace and magnitude of its balance sheet reduction, which should start over the next three to four months.
In his news conference afterward, Federal Reserve Chairman Jerome Powell indicated that the committee had made progress on a plan to do exactly that.
The primary takeaway from Wednesday’s meeting is that the Fed has no intention to permit inflation expectations—which are based on the five-year breakeven inflation rate that currently stands at 2.33%—from becoming unanchored.
But Powell went further, noting that the central bank is determined to restore price stability to the domestic economy.
The only significant questions in the near term that need to be answered are:
- Will upcoming rate hikes be 25 or 50 basis points?
- What will be the order and magnitude of balance sheet reduction, and will the Fed start to sell off its mortgage-backed securities?
- Does the Fed truly expect that it can bring the economy in for a soft landing given the almost impossible geopolitical, economic and financial crosscurrents it must navigate?
The “dot plot” now implies the Fed will hike interest rates six more times this year followed by four times in 2023. That forecast indicates that the Fed intends to take the policy rate into restrictive terrain above its long-run terminal rate of 2.4% based on the Summary of Economic Projections.
The Summary of Economic Projections points to a slower pace of growth this year near 2.8%, down from 4%.
The Fed did not alter its long-run growth rate, which remains at 1.8%, and the full employment rate level of 4%.
The Summary of Economic Projections points to a slower pace of growth this year near 2.8%, down from the 4% that it forecast at the December meeting, with economic expansion next year now expected to increase at 2.2% and 2% in 2024.
The inflation rate is now expected to finish the year at 4.3% in contrast with the 2.6% forecast at the end of last year. It is estimated to ease to 2.7% next year and 2.3% in 2024. The unemployment rate now is anticipated to fall to 3.5% by the end of the year, remain there next year and increase to 3.6% in 2024.
We expect that the growth forecast for next year will need to come down further, below 2.5%, and the inflation forecast will need to be increased substantially, likely near 7.5%, at year’s end.
These forecasts were put together before the latest spate of data from the real economy and the reality of the global economic shock became unmistakably clear.
With Europe likely falling into recession later this year and the global energy shock cascading throughout the economy, growth will slow and inflation will rise in a manner that is not consistent with this forecast.
In our preview of the FOMC policy decision, we wrote that conditions are simply too volatile to put forward a coherent forecast at this time and everything must be placed in a context of “revisions to come.” We will maintain that view until the pervasive uncertainty surrounding the current domestic and global economic outlook abates.