Written by Blerina Uruci.
Blerina Uruci, US economist at T. Rowe Price, previews Wednesday’s FOMC meeting and shares her monetary policy outlook for the remainder of 2022 and beyond.
Fed not ready to declare inflation victory
On Wednesday, I expect the Fed to increase the federal funds rate (FFR) by 75 basis points (bp), to 3-3.25% – in line with consensus. A 75bp hike in the funds rate has been priced in by the market since the blackout period started, while the upside surprise in the August CPI led to pricing in a low probability of a 100bp hike.
The Fed maintains a tightening bias and is not ready to declare victory on inflation. However, the future pace of hikes and destination remain data dependent. At a minimum, the Fed needs to clarify the conditions required to step down the pace of hiking to 50bp. The level of the FFR should help. Hiking ‘expeditiously’ was appropriate with rates below neutral, but ‘purposefully’ would be more suitable now interest rates are restrictive, and housing and consumer spending are slowing. Pausing altogether is not an option, given the hot labour market and sticky inflation.
Uncertain rate path as data remains mixed
The problem for the market is that the data are giving mixed messages. Inflation remains sticky, and the labour market is too hot. But growth is slowing, and the housing market is going through a significant correction. Looking to external factors, the energy crisis in Europe is coming to a head this winter and China is going through a painful adjustment. Fiscal support is trickling in both regions, but most feel it is not a match for the size of the problem.
I expect the FFR will likely be at 3.75-4% by year end, at which point the Fed will pause to see how the economy evolves and respond in 2023. Given my view the economy would muddle through, and price pressures would moderate beyond energy and food, I expected the Fed would hold rates around 4%. While I still have strong conviction the Fed will bring rates to about 4%, what happens beyond this is much more uncertain. Forecasting monthly data with any degree of certainty has been even harder than usual during this recovery.
Three rate scenarios for 2023 – in order of likelihood
- Central scenario: Terminal rate stays close to 4% in 2023 and the US economy muddles through. Growth slows significantly below potential – which is 1.5-2% – inflation pressures ease, the unemployment rate increases by not more than 1 percentage point (pp) from current levels. The central scenario would be consistent with a terminal rate at 4% plus or minus 25bp.
- Upside scenario: Terminal rate goes to 5% in 2023, as inflation remains sticky and the labor market too tight. So, even with growth significantly below potential, the Fed has to keep hiking. This can materialise if higher wage inflation becomes entrenched and firms can continue to pass through input cost increases to consumers. This implies at least a 100bp upside to the central scenario.
- Downside scenario: The Fed cuts interest rates in 2023 – as the US enters into a recession early next year, the unemployment rate increases by more than 1pp, and inflation slows dramatically with help from supply chains and dropping demand. The Fed gets the message it has overshot, and course corrects in the second half of the year, but not by moving to the zero lower bound immediately. This implies about 100-200bp downside to the central scenario.
The central scenario – higher for longer and with interest rates close to 4% – is still most likely. Although some consumer prices will correct in the coming months, there is an element of stickiness in inflation and heat in the labour market that requires higher rates. While the US is in a relative bright spot versus the rest of the world, it cannot exist in isolation to what is happening in Europe and China, which puts a ceiling on how high rates can go.
The upside scenario is the next most likely outcome. I found the August CPI report disconcerting, because it showed a persistence in sticky services inflation we have not seen for a long time. Inflation uncertainty is also high, and firms are still paying a premium to attract or retain staff. I also think there is a large degree of savings in higher income households in the US, which might allow firms to pass through price increases even as the economy weakens.
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