By raising interest rates by its largest amount in 28 years, the Federal Reserve signaled a newfound determination to weed out inflation, even at the cost of an economy that appears poised for a slowdown.
On Wednesday, Fed announced it was raising the federal-funds rate by 0.75 percentage point, the biggest interest-rate increase since 1994. This represents a hawkish policy pivot, coming from a Fed that has been signaling a smaller increase, of 0.50 percentage points.
With the latest increase, the federal-funds rate becomes 1.5% (the bottom of the target range), from 0% at the start of the year. Futures markets suggest the federal-funds rate will reach 3.75% by the first quarter of 2023 consistent with Fed officials’ forecasts.
And so far that’s how markets have taken today’s hike: as a long way from a one-off. The Fed has already indicated a tilt toward a more hawkish position, and its resolve regarding getting inflation under control has become a more urgent priority. We believe the market is right to price in this shift in the Fed's posture.
The two-year US Treasury yield is up roughly 0.6% in the past two weeks and the 10-year US Treasury is up about 0.4%. This has contributed to a sharp increase in bond yields that began late last year. Because bonds already reflect expected increases in the federal-funds rate, they are beginning to affect the economy.
That has crushed housing affordability, with the 30-year mortgage rate now approaching 6%. This is sure to have a significant negative effect on housing demand and (eventually) construction activity. Long before the recent uptick in rates in the past few weeks, we had already anticipated around a 10 percent decrease in housing starts in 2023, and now it is likely to be even worse. Housing will be a key contributor to the overall slowdown in gross domestic product’s rate of growth.
For now, we don’t forecast a full-blown recession, but with our baseline case featuring slower GDP growth, the risk of a recession has increased. We expect 2.2% real GDP growth in 2023; the Fed auctions 1.7%. And while the Fed is hoping to avoid a recession as collateral damage in an aggressive fight against inflation, it seems comfortable with the risk.
Labor markets have almost fully rebounded. The unemployment rate is already essentially at its pre pandemic level, and the overall employment rate not far behind as the rate of labor force participation starts to bounce back. This conjunction of factors would generally mollify bond traders, as evidence of economic slowdown is always expected to precipitate some near-term deterioration in the labor market, but the Fed’s own progress toward its full-employment mandate is light-years ahead of its success at its low-inflation mandate.
Near-term inflation data had disappointed relative to expectations that signs of progress would soon start to show, Fed chair Jerome Powell said. The Consumer Price Index rose 8.6 percent year-over-year in May. We argued that today’s stubbornly high inflation made the 0.75% hike more likely for the Fed meeting in June, which was published.
The Fed’s success at quelling high inflation will hinge on how quickly supply shocks like the blow to Russian oil supply and the global semiconductor shortage can work themselves out. Meanwhile, if long-run inflation expectations increase and stay up there, then inflation will be high even if the Fed manages to slow the economy slightly. That would again require more draconian moves by the Fed to shift the trajectory of inflation up as expected.
