Review the latest Weekly Headings by CIO Larry Adam.
- Anticipating the third consecutive 0.75% rate hike
- Retailers are discounting as they offload inventories
- The streak of declining gas prices continues
All eyes are (still) on the Fed! With the August inflation reading coming in hotter-than-expected, investors are looking to next week’s Federal Open Market Committee meeting (September 20-21) where Chairman Powell will provide the latest bird’s eye view of the US economy. The markets quickly and upwardly recalibrated expectations for an aggressive for longer Fed as pricing pressures permeated the broader economy, and investors prepared for the third consecutive 75 basis point rate hike! In addition, we will get the release of the updated economic projections and dot plot as well as the Chairman’s press conference. The financial markets will be closely watching to see how the Fed balances its focus on inflation (e.g., the increase in the terminal value of the fed funds rate) with the risk of recession.
- Keeping An Eye On The Fed’s Projections | The market’s expectations surrounding the future pace of inflation and the accompanying Fed policy has been fluid recently as so much has happened since the Fed last updated its economic projections on June 15—one interest rate hike, three months of economic data, and another earnings season (including CEO forward guidance). Over this time, consensus 2022 growth estimates have fallen (from 3.9% at the start of the year to 1.8% now), inflation has cooled (albeit not as quickly as desired), and the market’s anticipated peak policy rate has risen above 4%. Below is our summary of how we believe the Fed will revise its economic projections and policy outlook at next week’s meeting:
- Economic Growth | At the June FOMC meeting, the Fed lowered its 2022 GDP forecast from 2.8% to 1.7% and its 2023 forecast from 2.2% to 1.7%. While we do not expect a substantial shift to this year’s forecast, the 2023 GDP growth rate will be lowered as the current 1.7% level is well above our forecast of -0.5% and the consensus estimate of 1.1%. Our below-consensus forecast is due to rates soon entering restrictive territory (e.g., fed funds >2.75%) and the lagged effects of tightening policy.
- Inflation | The August Consumer Price Index report did not ease as expected, but the peak level appears to have been reached in July. While the natural assumption would be that the Fed’s targets for headline and core inflation (2022 estimate 5.2% and 4.3% respectively) may be unattainable, we do not agree. Why? Heading into fall, some of the hotter monthly prints from last year (0.9% in October & 0.7% November) will be ‘rolled off.’ Combined with evidence of easing pricing pressures in multiple areas of the economy (e.g., commodities, goods, etc.), the more significant deceleration may be just a few months away.
- Unemployment | The Fed’s 2022 employment target of 3.7% is likely to be revised slightly higher but should remain below 4% due to the resilient streak of job gains and still near record level of job openings. However, as economic momentum slows, companies will slow the pace of hiring and the unemployment rate is likely to approach the 4.7% level next year.
- Federal Funds Rate | As of June, the Fed’s 2022 and 2023 fed funds target was 3.4% and 3.8% respectively. But since then, inflation has not eased as quickly as anticipated, and the Fed has reiterated its focus to tame it. Our forecast is that the 2022 target should be raised to 4%, and that the 2023 target will hopefully be the same. While the market is pricing in a peak rate of 4.4% in the early months of 2023, we think easing inflation will limit the need for the Fed to be this aggressive. But as this is likely the most important number for the markets, a rate approaching 4.5% or higher would be a negative for equities.
- Press Conference | In our view, Chair Powell set the stage for further tightening at the Jackson Hole Symposium as the lower-than-expected inflation print in July was not enough to set a new trend and markets had already begun pricing in rate cuts by the end of 2023. Since then, he has stated that ‘some pain’ may be ahead due to higher rates while concurrently assuaging fears that the economy was headed for a recession. While he has been successful at threading the needle thus far (see chart below), any sign that the Fed is behind the curve or that more acute economic pain is ahead could unsettle markets.
- Keeping An Eye On The Fed’s Projections | The futures market has now fully priced in a 75 basis point hike at next week’s September FOMC Meeting (we agree). We foresee an additional 75 basis points before year end (combined at the November and December meetings) which brings the policy rate to 4%. Our projected policy path thereafter remains far more patient than what the market is expecting. Our reasoning? First, the action taken thus far has already impacted the more interest-rate sensitive areas of the economy, especially the housing market. Second, although the easing of inflation has been more stubborn than expected, there are a number of real-time indicators that suggest it will cool further in the months ahead (e.g., promotional activity, declining ocean freight rates, lower commodity prices). If a convincing pattern of decelerating inflation is established and more signs of demand destruction become evident, the Fed can pause and patiently assess the suitability of further action.
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