Fed signals 4.5% in the upper bound by December

Given this signaling, and the close proximity of the projected rate rises, we are upgrading our forecast for the peak in the fed funds rate upper bound to 4.5% from 4% previously. This is likely to be reached via one further 75bp hike at the November FOMC meeting, and a 50bp hike at the December meeting. This will take rates well into restrictive territory, assuming an estimated neutral rate of 2.5%. In addition to the rates projections updates, the FOMC also significantly downgraded its GDP growth forecasts, with growth now expected to end 2022 at 0.2% y/y – now much closer to our own forecast of 0.1%, and down from FOMC’s June projection of 1.7%. Inflation forecasts were also revised up again, but by much smaller magnitudes than in previous projection rounds. More significantly, the Fed has become more realistic in its labour market assumptions, and it now expects a modest rise in unemployment next year to 4.4%, up from its previous 3.9% expectation. This is still too sanguine an expectation, in our view, but it suggests the Fed is becoming more comfortable communicating that some pain will likely be necessary to bring inflation durably back to target. 

We still expect rate cuts in 2023, but from a higher level

The Fed’s updated projections showed policy staying well into restrictive territory throughout its forecast horizon to 2025, with no rate cuts projected until 2024, and policy still above neutral even in 2025. Despite this, we continue to think the Fed is likely to modestly cut rates in the second half of 2023. We expect a steeper rise in unemployment than the FOMC projects, with unemployment expected to reach c.5% by end-2023. Given the lags with which monetary policy affects the economy – especially the labour market – we think the Fed will be confident that the economy is cooling sufficiently by the middle of next year. We expect inflation to fall substantially in the first half of 2023, helped by falling commodity prices, the easing in supply-side bottlenecks and cooling demand side pressures as consumption continues to stagnate. All of this should lead to some modest rate cuts in H2 23, although the higher level from which the Fed would be cutting means we are now likely to end 2023 at 3.5% in the upper bound of the fed funds rate, up from our previous 3% expectation. In the near term, the risks to policy continue to be to the upside, with more tightening potentially necessary if the labour market does not cool in line with our forecasts. However, the even tighter policy stance than we previously expected also raises the risk of a deeper downturn further out, and potentially larger rate cuts if inflation also moves more quickly back to the Fed’s 2% target.