Home Insights Macro views Slower, but higher, for longer

Slower, but higher, for longer

Market response

December 14, 2022
Seema Shah
Chief Global Strategist
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The Federal Reserve (Fed) raised policy rates by 50 basis points (bps) today, taking the benchmark rate up to 4.25%-4.5%. After four consecutive 75 bps rate increases, today’s move marks a downshift in the pace of monetary tightening. Yet, as Fed Chair Jerome Powell emphasized several times during his press conference, it is no longer the speed of tightening that is most important, but ultimately how far policy rates increase and how long the Fed holds them there. With the latest dot plot indicating a peak rate above 5% and no rate cuts next year, this is still a very hawkish Fed.

In response to the downside inflation surprise

After yesterday’s second consecutive downside inflation surprise, markets had wondered if Powell would soften his tone, and if the new Summary of Economic Projections (SEPs) may indicate space for rate cuts next year. However, the inflation data didn’t seem to impact the Fed’s outlook at all. Instead, Powell repeated that the Fed need to see a clear run of softening inflation data before they can feel confident about its path and reiterated that history warns against prematurely calling victory over inflation. Consequently, the SEP still showed a very slow deceleration in inflation next year.

Updates to the Summary of Economic Projections

The new dot plot and Summary of Economic Projections indicates a Fed that plans to take policy rates above 5%, believes that won’t be enough to push inflation quite down to 2% next year, but is also okay with both outcomes. Notably, the dot plot showed meaningful upward revisions:

  • The median projection has rates ending next year at 5.1%. This is 50 bps higher than the September forecast and implies that there is still a further 75 bps of tightening to go. With 5.1% reflecting the mid-point of the Fed range and implying an upper limit of 5.25%, this is exactly in line with our own Fed forecasts.
    • Powell was asked during today’s press conference if this peak rate would be reached via 25 bps increments or possibly a mix of 25 bps and 50 bps increments. He seemed to indicate that 25 bps increments were possible. If the Fed does indeed further downshift its pace of hiking at the next meeting in February, that would imply the peak rate is reached in May 2023.
    • 17 of the 19 participants believe that policy rates would need to rise above 5% next year, and seven see rates rising above 5.1%.
    • The other major takeaway was that the dot plot implied no rate cuts in 2023. As we have been noting for a while, this is a “higher for longer” environment.
  • The median projection then falls 100 bps in 2024 and a further 100 bps in 2025. This isn’t a significant deviation from the September projection, which had projected 75 bps of cuts in 2024 and 100 bps in 2025, and it still keeps policy rates above the Fed’s estimate of the neutral rate (2.5%).

The Summary of Economic Projections also showed some meaningful revisions:

  • The core PCE inflation forecast for 2023 was revised higher from 3.1% to 3.5%, and 2024 revised up from 2.3% to 2.4%, with inflation only falling to 2% in 2025. Headline PCE inflation saw similar revisions, expecting to hit 3.1% in 2023 and 2.5% in 2024. Putting the dot plot and inflation forecasts together, the Fed thinks that raising rates above 5% will only get inflation down to 2% at the end of 2025!
  • The unemployment rate is expected to rise from 3.6% currently to 4.6% in 2023 (4.4% previously) and 4.6% in 2024 (4.4% previously).
    • When talking about the labor market, Chair Powell repeatedly emphasized how strong and resilient it has been. He noted the vast number of job vacancies and believes that the U.S. can avoid a meaningful rise in unemployment just by employers pulling back on job openings. It sounds credible, but it’s also worth noting that it’s never happened before—once job openings fall, historically it has always led to meaningful job losses.
    • The Sahm Rule is still in play. Created by former Fed economist Claudia Sahm, it stipulates that recession occurs when the unemployment rate rises by at least 0.5%. In other words, if the Fed’s own unemployment forecast does pan out, it points to recession...
  • ...But the Fed remained coy about the possibility of recession. For 2023, GDP growth was cut from 1.2% to 0.5%—low, but not quite recession. Yet, with most Fed officials considering risks to be tilted to the downside, it’s fair to say they are far more worried about the economic outlook than they are willing to admit. Our forecasts see recession in Q3 next year, a clear response to the drastic monetary tightening that has taken place.

Powell conveys a clear message

With markets and investors hanging on every Fed move, Powell needed to clearly convey the Fed’s perspective heading into 2023, and broadly did so.

  1. Ongoing rate increases are still required, and rate cuts are not on the agenda next year.
  2. The downshift in the pace of tightening, from 75 bps to 50 bps hikes was a recognition of the lagged impact of monetary policy. He emphasized that the clear focus for investors should be the terminal rate—a slowdown in the pace of tightening should not be celebrated if the terminal rate has increased.
  3. In response to ongoing questions about the recent softening in financial conditions, Powell asserted that conditions should reflect the restrictive nature of Fed policy.

Heading into 2023, today’s FOMC meeting gave investors their best look at how the Fed will likely approach rates, inflation, growth and employment in the new year. Unfortunately for investors, with a forecasted economic downturn, but no subsequent Fed relief coming, it certainly looks like 2023 is going to be another challenging year for risk assets.

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Views and opinions expressed are accurate as of the date of this communication and are subject to change without notice. This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

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