March 17, 2022

Thomas Garretson, CFA
Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.

Central banks largely stood their ground this week with the Bank of England delivering its third consecutive rate hike since last December to bring its policy rate to 0.75 percent, while the Federal Reserve began its own rate hike campaign with a 25 basis point move to a 0.25–0.50 percent fed funds rate target range at its March 15–16 meeting. Despite rising geopolitical concerns and economic uncertainty, central banks seemingly, at least thus far, continue to prioritize getting inflation under control over managing potential downside economic and market risks.

But it was the Fed’s meeting that garnered the bulk of the headlines, and sparked the most market volatility this week—if only briefly.

Slow out of the gate, but more to come

With all eyes on the Fed’s rate hike plans, it was the median estimates of the Fed’s updated Summary of Economic Projections that showed policymakers now expect seven rate hikes this year, in line with current market-based pricing, but well above what we expected the Fed to project. Following this week’s move, and with six meetings remaining, that would suggest a 25 basis point rate hike at every meeting, to a policy rate range of 1.75–2.00 percent.

But even beyond that development, it was the extent to which the Fed now envisions rates needing to move in order to return to price stability, to 2.75 percent by the end of 2023, and above the Fed’s current estimate of the longer-run “neutral” rate for the U.S. economy of 2.40 percent, or the level below which monetary policy is seen supporting economic growth, and above which it is potentially restrictive. Where the Fed’s previous forecasts failed to reach that threshold over the entire forecast window, it could now be breached as early as next year. If the Fed maintains a 25 basis point-per-meeting pace into 2023, the policy rate would first exceed the Fed’s estimated 2.40 percent “neutral” rate for the economy as early as its March 2023 meeting.

As the first chart shows, the last time these two metrics converged was in 2019 when the fed funds rate of 2.50 percent matched the Fed’s “neutral” rate, which created sufficient market and economic stress to cause the Fed to begin a series of rate cuts, even before the onset of the global pandemic. So therein lies the next challenge for markets and investors to navigate as the Fed moves to tighten monetary policy, and perhaps aggressively so.

The Fed’s updated rate hike timeline shows monetary policy could restrict economic activity by end of 2023

The Federal Reserve's updated rate hike timeline

The line chart shows the fed funds rate and the Fed’s estimate of the “neutral” rate for the economy from December 2011 through March 16, 2022, and the Fed’s projections through 2024. The most recent fed funds rate forecast shows a steeper increase than the December 2021 forecast, and projects that the fed funds rate will reach 2.8% by the end of 2023, exceeding the projected neural rate level of 2.4%.

Fed’s long-term estimate of “neutral” rate

Fed funds rate & current forecast

Fed's December 2021 Fed funds forecast

Source - RBC Wealth Management, Bloomberg, Federal Reserve; dashed lines show Fed’s projections

Price stability, but at what cost?

It wasn’t just the Fed’s upgraded rate hike projections that caught markets off guard, or the extent to which rates may rise this cycle, it was also the evolution of the economic outlook amid rising inflationary pressures, and waning economic growth prospects.

As the second chart shows, the Fed’s expectations for both economic growth and inflation have been moving steadily higher, and in tandem, since December 2020. But as inflation has proved more persistent in recent quarters, that has changed. The Fed’s updated numbers show headline inflation running at 4.3 percent this year, compared to a 2.6 percent estimate last December. Economic growth, on the other hand, received a sharp downgrade to 2.8 percent this year from 4.0 percent previously. Likely, and largely, it is a reflection of the Fed’s plans to raise rates more aggressively than thought before.

After rising in tandem, the Fed’s inflation and growth forecasts diverged sharply at the March meeting

Net change in the Federal Reserve's 2022 forecasts for inflation and GDP

The line chart shows how the Fed's economic projections for 2022 have changed since December 2020, with the March meeting showing a sharp upgrade of inflation expectations, paired with a notable downgrade of growth expectations.

Net change in 2022 inflation forecast
Net change in 2022 GDP forecast

Source - RBC Wealth Management, Federal Reserve; the Fed currently projects 2.8% GDP growth this year, with a headline personal consumption expenditures inflation rate of 4.3%

While this dynamic may further stoke the flames of “stagflation” fears, it’s important to note that GDP growth of 2.8 percent this year, and 2.2 percent next year, is still well above the 1.8 percent the Fed judges to be the long-term sustainable growth rate for the U.S. economy. But an aggressive rate hike timeline to above-neutral levels is one that could put monetary policy in a more precarious spot earlier than previously expected should the central bank battle against inflation come at the cost of the economic expansion.

Put in the work now to have options later

While no one wants to even utter the word “recession,” especially at a time when it still feels like the economy has barely left the last one behind, it’s the Fed’s outlook—paired with current market signals such as ever-flatter Treasury yield curves—that suggests to us that it may not be too early to begin exploring the likelihood, as well as the potential ramifications, of such an outcome of global central bank policy tightening.

Put simply, we continue to think the near-term recession risks are low, certainly in 2022, but not low enough to ignore into 2023. Analysts often look to the 1990s as an idyllic stretch where early Fed rate hikes in the decade succeeded in getting inflation under control, allowing the Fed to pause and to tweak policy as needed later on, which ultimately led to a sustained economic recovery. Given a strong labor market backdrop today, a scenario like this would be our base case.

As Fed Chair Jerome Powell noted during his press conference, “The goal, of course, is to restore price stability while also sustaining a strong labor market. In fact, it’s a precondition, really, for achieving the kind of labor market that we want, which is a strong and sustained labor market…”

It’s certainly too early to say whether the Fed can, in fact, engineer a soft landing for the economy. And while near-term market and economic risks may remain high as central banks seek to move early and aggressively, we think the longer-run backdrop remains on solid footing, and that central banks will ultimately retain flexibility in removing accommodation as appropriate down the road.

This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.

The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.

This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.

Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.

Thomas Garretson, CFA

Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.