Bad news forces Fed to up its game

US interest rates were hiked by 75 basis points on last Wednesday in the biggest move since 1994. The Federal Reserve (Fed) also signalled that future moves would be greater and that rates would rise further than previously expected. The so-called dot plot now has rates rising to 3.4% by the end of the year and to 3.8% by end 2023.

It is quite possible that the Fed would have stuck to its earlier plans of a 50 bps rise had it not been for a double whammy of bad news on June 10. Headline CPI inflation rose to 8.6% and inflation expectations also increased to 3.3%. Fears that inflation has become entrenched and the US is set to experience a wage price spiral were heightened by the figures.

Clearly, the economy will have to slow by more to bring inflation under control and the Fed also downgraded its growth forecasts to less than 2% for this year and next with higher unemployment. The Fed stopped short of forecasting a recession although chair Powell did say that factors beyond its control could make the outcome worse in his post-meeting press conference. He was referring to the Ukraine conflict and the risk of even higher commodity prices.

We had already expected policy to be tightened aggressively this year in our recent forecast update, although the pace of rate rises is now looking steeper. Nonetheless, we still believe that evidence of weaker activity and inflation will cause the US central bank to slow the pace of tightening and pause early in 2023.

Consumer spending is grinding to a standstill as higher prices cut real wage growth. Inventory levels have built up as unsold goods remained in the warehouse. The latest estimate from the Atlanta Fed is for growth of zero in Q2, bringing the US economy to the verge of recession after a negative reading in Q1. The labour market will also need to cool but weaker sales will cause firms to slow hiring as profit margins come under pressure.

As a consequence we would expect to see inflation easing later in the year and for the tone of Fed announcements to soften. Rates are more likely to be falling than rising by the end of 2023 in our opinion. In the meantime though further tightening lies ahead and an anxious wait for evidence that the economy is responding.