Bringing forward Fed rate hikes

Fed View: We now expect rate hikes to start early 2023

With this year’s inflation overshoot proving to be more persistent than initially expected, wenow expect the Fed to have fulfilled its dual mandate by the end of 2022, paving the way for a first hike in the fed funds rate in early 2023. Previously, we expected lift-off to happen in late 2023. We continue to expect only a gradual rise in rates following the first hike, with rates initially rising once every six months, compared to once per quarter in the previous 2015-2018 hiking cycle. Today we lay out our new base case for the Fed, with the implications for rates markets coming in a follow-up note tomorrow.

Inflation target already, or nearly, fulfilled

Under the Fed’s average inflation targeting framework, adopted a little over a year ago in August 2020, the central bank seeks “to achieve inflation that averages 2 percent over time.” The Fed did not specify what its ‘look-back’ period is for this, deliberately to give it maximum discretion and policy flexibility. However, on most reasonable timeframes – whether spanning the previous 3-4 years, or from the start of the current economic cycle in early 2020 – the Fed has either already met, or will very soon meet, its average 2% target (see chart below). Commentary from FOMC members also suggests that most see the target as having already been met, or that it will be met soon. 

…with full employment achieved late next year

The Fed’s mandate does not only involve inflation, but it also has a maximum employmentobjective. As long as these two goals do not seriously conflict, then, the Fed must also wait until maximum employment is achieved before raising interest rates. How do we define maximum employment? This typically refers to the level of employment reached before it triggers inflationary pressure in the economy. This is notoriously difficult to estimate with precision, but at present this is likely to be consistent with an unemployment rate of 3.5-4%. With unemployment currently at 5.2% in the US, and likely to continue its gradual decline over the coming year, we think maximum employment will most likely be achieved in late 2022. This would pave the way for a rate hike in early 2023.

With inflation so high, why not hike sooner?

Given how elevated inflation has been over the past year, it is not unreasonable to wonder why the Fed would wait this long to begin rate hikes. We would offer the following reasons. First, inflation is likely to fall back significantly next year, with demand-side pressures already starting to ease, and supply-side bottlenecks likely easing by the middle of next year. Monetary policy works with a significant lag (up to 2 years), and so raising rates now would do little to dampen the inflation we are seeing at present. Second, consumers seem to share the expectation that inflation will fall back, which is why surveys of longer-run inflationexpectations – although having risen a little – remain well-anchored and consistent with 2% inflation. A de-anchoring of inflation expectations would arguably be necessary to induce a wage-price spiral that warrants an aggressive tightening of monetary policy. A final key reason for the Fed to be cautious with rate rises is forward guidance credibility. Fed officials have long signalled that the end of asset purchases – likely around mid-2022 – would not beimmediately followed by rate rises. As such, there is likely a high bar to row back on this signalling. 

The Fed could hike sooner if inflation re-accelerates, or if expectations rise

The timing of lift-off naturally depends significantly on inflation developments over thecoming year. Our base case is that inflation will ease significantly, but given the persistence of supply-side bottlenecks, the risks to inflation remain tilted to the upside. Should inflation re-accelerate significantly, we would have cause to revisit our view. Another trigger to revisit our view is a shift in inflation expectations. At present, expectations remain well-anchored. If we start to see inflation expectations drifting beyond levels seen in the post-GFC period, this would be a major warning sign that a more forceful policy response would be required. On the other hand, there is also the risk that the Fed hikes later, if the unemployment rate declines more slowly than we currently expect – for instance, if labour supply (which has been depressed by the pandemic) recovers much more quickly. A final risk to our view concerns the pace of rate hikes. We expect the Fed to hike rates more gradually in the coming cycle than in previous cycles, partly because we think a more gradual approach is more consistent with the longer-run goal of an average inflation target, but also because the late-cycle cuts of 2019 suggests the Fed may have moved a little too aggressively last time around. However, should inflation remain above target once hikes begin (not our base case) it is possible that the Fed hikes at a more rapid pace than we currently expect.