North America June 15, 2022 / 08:26 pm UTC

Fed: Shift to “Moderately Restrictive”

By Mike Gallagher, Dave Sloan

Bottom line: The June FOMC meeting signals a shift to moderately restrictive policy in 2022.  The guidance is 50bps or 75bps at the July meeting, but remaining inflation momentum/tight oil market and current Fed hawkishness suggests that on balance 75bps is more likely. We then look for 50bps from the Fed in September and 25bps in November, which would bring the Fed Funds target to 3.00-3.25%. We then see weak economic data and a lower rises in monthly inflation numbers causing the Fed to pause and not hike in December – Powell noted that the (voting) FOMC members saw end 2022 at 3.00-3.50%.

Figure 1: 10yr Breakeven Inflation Stable (%) 

Source: Bloomberg 

Restrictive Policy with More Gradual Tightening After the Summer 

The June FOMC statement and Fed Chair Powell Q/A provide a number of clues on the pace and scale of interest rate hikes to come after today 75bps step. Key points include

  • Inflation/Dots. The FOMC statement makes clear that the Fed are “strongly committed” to returning inflation to 2%, which is a more intense objective than the previous wording that they expect inflation to return to 2%. The median SEP for core PCE inflation reflected these concerns over more persistent inflation (Figure 2) that will now mean a rise in the unemployment rate to 3.9% in 2023 according to the dots. The message in the Q/A session was that the Fed intends to consider 50bps or 75bps in July and get to around a 3.00-3.50% Fed Funds rate by end 2022 (though the dot median was 3.4%, the dots are all 18 members and Powell guidance is likely to be the 11 voting members).Powell also left the impression that headline inflation was perhaps attracting more attention within the Fed, as the public experience headline inflation rather than core inflation. Additionally, Powell indicated that the FOMC was concerned about the “eye-catching” jump in provisional May UoM 5-10yr inflation expectations to 3.3%, as inflation expectation coming back down is “very important” to the FOMC.  All of this points to a more hawkish and reactive Fed during the summer. 
  • Growth projections.  They have been trimmed (Figure 2), but still reflect a soft landing view from FOMC members and Powell Q/A noted a real sector pick up in Q2.  The 1.7% GDP forecast for 2022 is the biggest change and we see the May retail sales figure suggesting that high inflation is starting to depress real consumer activity for goods. Additionally, Powell noted narrow pathways to achieving the dual objectives, which could be read as a sign that FOMC members are concerned about downside economic risks around median forecasts. The dropping of strong labor market in the FOMC statement was explained by Powell, with the Fed still wanting a strong labor market and this will become applicable when the growth dips to stagnant levels (0-1%).By the end of the year, the economy will likely be weak enough to cause the Fed to pause.

2022 tightening. The 75bps hike to a 1.50-1.75% Fed Funds target and 3.00-3.50% Fed Funds twice noted by Powell would imply a further 150-175bps by end 2022.July’s most likely outcomes are 50bps or 75bps, with the Fed chair not wanting to be boxed in again but also reflecting a desire to fine tune the decision with incoming data. The problem is that gasoline prices will likely remain elevated, as the EU seaborne oil ban pushes WTI towards $130 and restricted refinery capacity pushes up gasoline and diesel during the driving season. On balance we feel that 75bps currently looks more likely in July. Follow-through hawkishness will then likely see a 50bps hike at the September FOMC, before slowing to 25bps in November. In Q4 the economic data should be weak and the economy showing real risk of stagnation (0-1%) growth or recession into 2023. Monthly inflation numbers should also be lower, which is something that Powell noted as a desire to track policy effectiveness. This should be enough to stop the Fed from hiking in December and we look for the Fed to pause. This would mean a 3.00-3.25% Fed Funds rate by end 2022.

Figure 2: Statement of Economic Projections 

Source: Federal Reserve 

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I, Mike Gallagher, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.