The early reaction to this week’s hotly anticipated Federal Reserve meeting was one of modest relief as the tone from Fed Chair Jerome Powell was relatively dovish despite an aggressive rate hike of 75 basis points (bps). In the run-up to the meeting, fears had increased that the Fed could launch an all-out assault on inflation after the Consumer Price Index reached a fresh high along with an unsettling rise in consumer inflation expectations just days prior to the meeting. But Powell appeared to take a nuanced view of inflation, and noted that many of the key factors fueling it remain largely out of the Fed’s control while downplaying the idea that 75 bps hikes could become the norm. However, it was little more than a fleeting moment of calm, as global central banks remain on the offensive, driving stocks lower, and sovereign yields higher.
Pump it up
The Fed has almost no good options at the moment, in our view, and uncertainty has only increased at a time when many had hoped it would begin to fade. That was evident this week as Powell offered little in the way of forward guidance, leading markets to the idea that the data would dictate the magnitude of upcoming rate hikes.
But as RBC Capital Markets, LLC Chief U.S. Economist Tom Porcelli noted this week, there’s a risk that the Fed will have to walk into its July 26–27 meeting with a nine percent year-over-year inflation print, and there may even be some upside to that number as the national average for a gallon of gas is already up nearly $0.40 through the midpoint of the month to $5.00. Just as Powell initially dismissed the idea of a 75 bps rate hike earlier this year, a number like that could put a surprising 100 bps move on the table. As it stands, the market is currently split on whether the July meeting will feature a 50 bps or 75 bps move.
As the first chart shows, the end result was that the Fed markedly pumped up its rate hike forecasts compared to its economic projections in March. And while the central bankers previously foresaw holding rates flat from 2023 into 2024, they now see the potential for rate cuts.
Front-loaded and higher rate hikes seen leading to earlier rate cuts
Fed rate projections and market expectations
Line chart showing how the Fed's rate projections shifted sharply higher in June from the March meeting, with policymakers now seeing policy rates at 3.375% this year, and peaking at 3.75% next year. While the Fed sees rate cuts in 2024, the market sees potential rate cuts as early as 2023.
Source - RBC Wealth Management, Bloomberg, Federal Reserve median rate projections; Market expectations based on Overnight Index Swap Rates
Market pricing is even more aggressive, not only in terms of front-loading rate hikes this year, but also in terms of rate cuts, now seen potentially as early as 2023. But it remains to be seen whether the market is pricing those rate cuts next year in response to recession risks, or because it expects the Fed will have achieved its goal of bringing inflation down and will therefore be able to make some insurance cuts in order to deliver a soft economic landing and to support continued economic expansion.
A global challenge
Inflation isn’t just a U.S. problem, but rather a global challenge. As the second chart shows, headline inflation appears yet to peak across major global economies.
Global inflationary pressures persist as central banks wait for confirmation of a peak
Monthly CPI and quarterly consensus forecasts
Line chart showing historical and projected Consumer Price Index inflation from December 2018 through December 2023 for the UK, U.S., and European Union. Inflation is expected to begin declining from current levels soon, and to be near the target level of 2.0% at the end of 2023.
Source - RBC Wealth Management, Bloomberg consensus forecasts based on Bloomberg Analyst Survey for June 2022, shown by dashed lines
While the Fed has been widely criticized (perhaps justifiably) for coming too late to the rate hike game, the Bank of England—the first of the major global central banks to begin raising rates—has only seen inflation continue to accelerate in the UK. This makes it more likely that policymakers across the pond will deliver their own supersized rate hike of 50 bps at their next meeting, in August, following a fifth consecutive 25 bps move this week.
Consensus expectations call for UK inflation to remain near its current elevated level for the remainder of the year, while in the U.S. and Europe, both markets and policymakers are now expected to get their first indication that inflation is on the move lower by the fourth quarter. In light of these expectations, our base case is now that the Fed’s aggressive rate hike campaign will continue for the balance of 2022, but that policy rates will be held flat into 2023 as the chances for rate cuts grow.
Inflation is one thing, growth is another
While inflation remains the primary concern of central banks and investors alike, we believe the focus will pivot back to economic growth sooner rather than later. In the U.S., following this week’s economic data on consumer spending and the housing sector that showed a sharp slowdown on the back of mortgage rates breaching six percent for the first time since 2008, the Atlanta Fed’s GDPNow model is currently projecting flat economic growth in Q2, down from an estimate of 1.9 percent growth on April 29, following the Q1 pullback of 1.5 percent. We think this could cause markets and policymakers to turn their focus toward growth concerns when the first official Q2 GDP estimate is released on July 28, just one day after the Fed’s next meeting.
As the last chart shows, the Fed now envisions that its ramped-up rate hikes this year will cool economic growth below its potential levels this year and next—which naturally will relieve inflationary pressures. Note that the Fed is not targeting an economic contraction or recession in order to achieve this, just a stretch of below-trend growth. Should this effort succeed, the Fed’s view that rates could fall in 2024 would then boost economic activity to above-trend levels.
Fed envisions modest growth slowdown to tame inflation, but reacceleration by 2024
The chart shows the most recent U.S. Federal Reserve GDP current growth forecasts compared to the March projections for 2022 (current: 1.7% vs. March: 2.6%), 2023 (1.7% vs. 2.2%), and 2024 (1.9% vs. 2.0%), and 2021 actual GDP growth (5.5%). The updated growth forecasts are below long-term estimated potential economic growth of 1.8%.
Change in Fed's GDP forecasts from March
U.S. GDP growth (y/y)
Fed's estimate of long-term potential GDP
Source - RBC Wealth Management, Bloomberg, U.S. Federal Reserve; dashed line shows projection based on Q4 year-over-year data
We think the Fed will ultimately err on the side of caution as core inflation (excluding food and energy prices) has arguably shown signs of peaking, and should continue to fall faster than headline inflation as excess inventories and a cooling housing sector weigh on prices. While policymakers can’t ignore high headline inflation and the risks it poses to inflation expectations, it may prove to be the case that investors and consumers hate the alternative to high inflation more than they hate high inflation. As Porcelli also noted: “Do they [Fed policymakers] just keep raising rates aggressively in the face of firm pump prices they have limited if any meaningful ability to control? It’s hard to believe that’s actually what they want to do. The economic repercussions from following this approach for even a modest stretch of time would drive us into something potentially ugly.”
Finally, while recession talk and the risk of an economic downturn have both increased as a result of aggressive policy tightening campaigns—and are likely to continue to do so, in our view—such an outcome is not inevitable. To a large extent, market valuations may already reflect those risks; and while the word “recession” always has an unpleasant connotation, neither the depth nor the duration of any potential pullback would be easily gauged in advance. We suspect that a mild contraction in economic activity could allow supply chains time and space to recover, setting the stage for a more sustainable expansion in the aftermath.
There may be no good answers … there might not even be any answers. But central bankers will keep working to control the things they think they can control, while higher rates won’t necessarily cool demand for food or boost oil production. And while inflation remains front and center, growth concerns will remain back-of-mind, and could move into the driver’s seat of policy choices sooner than many might appreciate.
In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc. which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RBC Dominion Securities Inc.
Fixed Income Strategies
Portfolio Advisory Group – U.S.