FOMC Preview: 25bps Tightening, Scenarios Looking Ahead
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Bottom Line: The FOMC meets on July 26 and a 25bps tightening to a 5.25-5.50% range still looks likely, even with recent encouraging readings on inflation. Given uncertainty on how sustainable the progress on inflation will prove, the Fed will give little away on the future outlook. Our central view is that one more tightening will be seen, in November, but we will consider four separate scenarios, under differing growth and inflation outcomes.
No shocks from the decision, or the statement
At the last meeting, on June 14, the FOMC left rates unchanged for the first time since tightening started in March 2022. This was despite employment and inflation data between that meeting and the previous one on March 22 having surprised to the upside. Minutes for the June meeting showed that some wanted to tighten, but all eventually agreed to skip at the meeting. Approaching this meeting the latest employment and inflation data have surprised to the downside, though the former was still strong. The latter, while genuinely encouraging in its detail, was the first such outcome after a six month string on disappointments, and does not make a trend. Fed Governor Christopher Waller recently said two more good CPI prints might suggest stopping tightening. Other Fed speakers interpreted the data similarly cautiously.
There are some reasons to hope that the CPI softening can be sustained, with many price surveys and PPI trend having returned to near pre-pandemic paces, but the Fed cannot count on it and will leave future policy data-dependent, with further tightening possible and no discussion of easing seen in the near term. .Just as the June meeting saw no formal dissent from the decision to hold we expect July’s will see no dissent from a decision to tighten, though a few FOMC participants may question the need to tighten again. We doubt the Fed will change the statement’s assessment of the economy much from June’s. They may add a caveat to the view that inflation remains elevated, but they may also tone down a reference to the downside risks from tighter credit conditions. In the forward looking section, a reference to “the extent of additional policy firming that may be appropriate” will probably remain, though if a caveat such as “any” were added, it would be seen as a dovish signal.
Fed policy outlooks under differing growth and inflation scenarios
Given the uncertainty going forward, and the likelihood that the Fed will leave future policy data-dependent, we consider four scenarios for future data. On inflation we consider two separate scenarios, firstly stubborn inflation, with core rates averaging 0.3% or more through the second half of this year, and secondly a sustained improvement with core rates averaging 0.2% or less. On activity, we consider an upside scenario of growth sufficiently strong to mean no significant labor market slowing, with the unemployment rate near stable. This would probably mean GDP growth of around 2.0% but slower is possible if productivity is weak. The downside scenario sees a significant easing in labor market conditions. This could see subdued GDP growth or a mild recession. We do not have a specific recession scenario as risks of a sharp recession have faded with banking sector worries not having escalated further. This leaves us with four scenarios overall.
Scenario 1 (40%) Stubborn inflation, easing labor market. This is the scenario outlined in our June outlook. We would then expect the Fed to follow a July tightening with a final move in November, taking the Fed Funds target to 5.50-5.75%, before easing starts in Q2 2023. This assumes core inflation gains not much above 0.3%, slower than the first months of 2023. Gains around 0.4% would see more tightening and easing staring somewhat later.
Scenario 2 (30%) Sustained inflation improvement, easing labor market. Under this scenario no further tightening would be likely. The Fed is likely to skip in September even without weak data, and by November the change in trend would be convincing. Easing could commence in Q1 2024. 2024 easing could be a little more aggressive than the 0.25% per quarter that we see in Scenario 1 (starting in Q2 for a total of three moves).
Scenario 3 (20%) Sustained inflation improvement, strong labor market. With supply improving subdued inflation could return even with resilient demand. There would be no clear need for the Fed to tighten again after July’s move. However policy would probably be held steady well into 2024. Even if the improvement is sustained near term, holding inflation sustainably at 2% would be difficult without some labor market easing.
Scenario 4 (10%) Stubborn inflation, strong labor market. We feel this is the least likely scenario as stubborn inflation would weigh on the economy though real disposable income and rising bond yields. Under this scenario the Fed Funds target would reach 6% in early 2024 with potential for more, with easing only seen once the economy sees a potentially sharp loss of momentum sometime in 2024.