For the first time in this rapid U.S. rate cycle, I now think the Fed has moved into ‘overkill’ territory.
I was bothered by two specific things from Wednesday’s FOMC:
I saw no point in highlighting the Fed’s goal to get inflation back down to 2%; that is miles (or, more likely, three years) away at best. That could be read by the market as projecting ‘above-neutral’ interest rates for 2-3 years.
There was no need for the Fed to signal so overtly that Fed Funds would be raised by another 75 basis points next meeting before a potential slowdown to a 50 bps hike in the last meeting of 2022. That would leave Fed funds at 4.25-4.5% at year-end or, as the dot plot says, 4.4%.
These two points—one verbal and one a forecast because that is what the dot plot is—have increased, in my view, the risk of recession in the U.S. economy and do not appear justified by the economic data.
I was asked in a media interview if the Fed ‘wanted’ to drive the economy into recession. I said no, but sometimes you wonder.
On the data front, as I have said ad nauseam, the August inflation data was not awful. The last two months’ headline CPI reports have been soft (-0.1% and +0.1% month-on-month) and the year-on-year is falling albeit slowly. (Moreover, there is only one more month of difficult comps with last year after which the YOY rate should start to fall more quickly.)
Although, it was the 0.6% core inflation report for August that spooked the markets, there have already been four core monthly gains of 0.6-0.7% earlier in 2022—and, the year-on-year rate here is also falling.
In short, inflation is not accelerating; it is falling on both core and headline, just less rapidly than the market was assuming. This is no reason for policy overkill.
I understand the point about getting to the terminal rate (now forecast by the Fed at 4.6%—implying one more 25 bps rate rise in 2023)—quickly.
However, there was no need to upset the market with the above two comments, unless that was actually the Fed’s goal.
Also, I have said for some time that, as we head into 2023, there will be visibility that inflation by end-2023 will be close to 4%, meaning positive real rates by then; that is a better way to express the policy goal than to bang on about 2% inflation.
I retain my view that equities likely hit bottom at 3,666 on the S&P in mid-June (3.5% below Thursday’s close); I am a long-term buyer.
The best news was the relative stability of the 10-year yield (in a 3.5-3.6% range), while the two-year rate soared. That steeper curve inversion suggests the market thinks the Fed is, indeed, getting on top of inflation while, at the same time, the risk of recession has materially increased.
The latest rise in the dollar means no respite for EM from this direction. Nonetheless, EM is still holding up fairly well in a lousy year for equities: EM-24.9% (in $); DM:-22.1%.