Markets

Listen to the (More Hawkish Fed) Music

December 15, 2022

5 minute read

by Liz Ann Sonders, Chief Investment Strategist, and Kevin Gordon, Charles Schwab & Company Ltd.

The Fed hiked interest rates by 50 basis points in December, and while progress has been made on inflation, Fed Chair Powell noted it is too early to declare victory.

As expected, the Federal Open Market Committee (FOMC) raised the fed funds rate by 50 basis points to a range of 4.25% to 4.5%, in a unanimous decision. It represented the first "step down" in the pace of rate hikes from the prior four consecutive 75-basis-point hikes. The 425 basis points of cumulative rate hikes in 2022 are the most in a year since 1980.

The Federal Reserve's median forecast (full dots plot shown below) shows the fed funds rate hitting a "terminal rate" of 5.1% in 2023 and 4.1% in 2024. Prior to today's announcement, the market was pricing in a terminal rate of 4.8% by May 2023 (post-meeting today it was 4.9%), with rate cuts totaling 50 basis points by the end of next year.

In the accompanying statement, the Fed repeated that "ongoing" rate increases are likely appropriate, indicating at least one more rate increase at the February meeting, and possibly also at the March meeting. The distribution of rate forecasts skewed higher, with seven of 19 FOMC officials projecting a fed funds rate of more than 5.25% next year (five at 5.4% and two at 5.6%).

The distribution of the dots shows a more hawkish tilt relative to the broader universe of private-sector economists. Prior to today's meeting, only five of 65 forecasters surveyed by Bloomberg saw a fed funds upper-bound target rate of above 5.25% next year. The initial reaction by stocks was a move down off the day's high, with bond yields moving higher.

The Fed sees rates at 5.1% by end of 2023, 4.1% by end of 2024 and 3.1% by end of 2025.

Source: Bloomberg, as of 12/14/2022.

The FOMC also released an update to its Summary of Economic Projections (SEP), clearly showing Fed officials' expectation of further economic hits to come from monetary policy changes so far. As detailed below, although economic growth forecasts for 2022 were lifted slightly, they were downgraded to 0.5% growth for 2023, down from 1.2% as of September. They also upped their unemployment rate projection for 2023 to 4.6%.

The Fed's median forecast shows 2022 GDP at 0.5%, unemployment at 3.7%, inflation at 5.6% and core inflation at 4.8%.

Source: Charles Schwab, Federal Reserve, as of 12/14/2022.

Note: Projections of change in real gross domestic product (GDP) and projections for both measures of inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal consumption expenditures (PCE) and the price index for PCE excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated. Each participant's projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant's assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. The projections for the federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. ¹For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. ²Longer-run projections for core PCE inflation are not collected.

In sum, nearly all FOMC officials see downside risks to their GDP projections; nearly all of them also see upside risks to their inflation projections. There is now one official, however, who sees downside risk to inflation—a very slight shift from September's SEP.

Presser with Fed Chair Jerome Powell: highlights (from first 40 minutes)

Monetary policy needs to remain tight "for some time" in order to restore price stability.
"Our focus is not on short-term moves, but on persistent moves."
The past two months' downtrend in inflation is promising, but it will take "substantially more evidence" to boost confidence in the downtrend's sustainability.
"The labor market remains extremely tight."
FOMC officials expect the labor market to come into better balance "over time."
"Reducing inflation is likely to require a sustained period of below-trend growth and some softening of labor market conditions."
"Over the course of the year, financial conditions have tightened significantly. Financial conditions fluctuate in the short-term in response to many factors, but it's important that over time they reflect the policy restraint that we're putting in place."
Policymakers will continue to look at incoming data and make decisions on a meeting-by-meeting basis.
"We will stay the course until the job is done."
There was a focus on "non-housing core services"—closely tied to the labor market—with Powell noting that persistent ("stickier") inflation there is why the Fed's rate projections were increased.
"Goods inflation has turned pretty quickly now, but there is an expectation that the services inflation will not move down so quickly."
Wage gains are running "well above" what would be consistent with the Fed's 2% inflation target.
"Generally, companies want to hold onto the employees they have. That doesn't sound like a labor market where a lot of people will need to be put out of work."
The Fed doesn't see any meaningful increase in the labor force participation rate due to demographics/retirements, less immigration and COVID-related issues.
We "won't consider rate cuts" until the Fed is confident in inflation coming down toward 2% in a "sustained way."

In sum

Powell's goal during the press conference appeared geared toward reinforcing that more tightening is to come—of not just rates, but also financial conditions (which have loosened recently)—and that financial markets need to be prepared. Irrespective of the softer-than-expected November CPI report, the message emanating from today's announcement/presser is that the Fed has less concern about over-tightening and is more focused on avoiding the error/consequences of under-tightening.

Powell emphasized that financial conditions reflect "policy restraint instituted by the Fed," with policy actions working "through financial conditions." He was particularly clear about the Fed's indifference to short-term swings in financial conditions (and didn't specifically push back against the recent loosening), but that they want to "control" them over time.

Powell noted that "by now, we expected to make faster progress on inflation than we have." He appears to have left the door open for either a 25- or 50-basis-point hike at the February FOMC meeting, depending on incoming data. What is easy to conclude is that Powell and most other FOMC officials do not yet believe that monetary policy is yet sufficiently restrictive.

Bouts of volatility across both the equity and bond markets should be expected, at least between now and the next FOMC meeting in February. Although one could infer that rates don't have much more to go on the upside, Powell did make it clear that the Fed wants/expects slower economic growth as a necessary ingredient in the recipe of sustained lower inflation.