Fed Watch - Still hawkish, but early signs of a shift
Fed View: Baby steps towards a pivot – The FOMC raised the target range for the fed funds rate by 25bp to 4.50-4.75%, as was widely expected. With no update to the Committee’s projections at this meeting, and negligible changes to the policy statement, the focus was on Chair Powell’s subsequent press conference remarks. While Powell maintained a broadly hawkish tilt, reading between the lines of his remarks, we see the first baby steps towards a looming pause in rate hikes following the expected March hike, and – ultimately – a pivot to rate cuts later this year.
First, contrary to our expectations, Powell appeared surprisingly relaxed with the recent easing in financial conditions, with him remarking that ‘financial conditions moved sideways’ since December (there are different ways of looking at financial conditions, but the Bloomberg index has eased significantly). Second, while Powell repeated many of the hawkish refrains of recent press conferences, he made all of this contingent on the economy evolving as the Committee expects. For instance, the forward guidance in the statement continued to be for ‘ongoing increases’ in rates – with Powell later clarifying that the Committee expects a ‘couple more’ hikes to be appropriate. Powell also said he did not expect rate cuts in 2023. However, all of this came with the caveat that the Fed would continue to act in a data dependent manner. Indeed, Powell noted that the Committee does not expect a recession, and that inflation could decline more quickly than expected. While the near-term goal of policy is therefore to get ahead of the risk of inflation becoming entrenched, Powell signalled that should the economy evolve differently to the Committee’s current base case, that this would naturally then figure into the FOMC’s policy deliberations.
We think a mild recession is unfolding, with inflation near 2% by end-2023…
Our expectation is that the economy will indeed surprise the Fed’s forecasts. We think the US is already entering a mild recession, with declining consumption late in Q4 likely driving a contraction in Q1 that extends into Q2. We also expect inflation to be broadly back at the Fed’s 2% target by the end of 2023, in contrast to the FOMC, which as of the December projections expects inflation still somewhat above target (the median FOMC forecast for PCE inflation is 3.1% (Q4/Q4), compared with our forecast of 2.1%).
…supporting our call for 125bp in rate cuts by late this year
While we expect the Fed to maintain a broadly hawkish tone at the upcoming March meeting, we think its tone has already begun to shift, and that this process will continue as the data increasingly points towards a weakening economy and a more rapid decline in inflation than the Committee currently projects. Our base case is for the Fed to pause policy tightening following its next 25bp hike in March, with a tightening bias remaining initially. Powell today explicitly referenced the Bank of Canada’s approach, where it communicated that it is ‘prepared to increase the policy rate further if needed to return inflation to the 2% target’. We see the Fed adopting similar language in March. However, we think further rate hikes will ultimately prove unnecessary, and that by September, the Fed will be ready to start pulling back from the current highly restrictive policy stance. Our base case is for a total of 125bp in rate cuts in late 2023, which would leave the fed funds rate at a still-restrictive level of 3.50-3.75% by year end. (Bill Diviney)