Snapshot

Fed ready to bring the pain in inflation fight


Investors took fright after the Federal Reserve (Fed) hiked rates by another 75 basis points to 3.25% and vowed to “keep at it”.

The S&P 500 closed 1.7% lower, while the Treasury curve inverted further as two-year yields topped 4.1% for the first time since 2007. But Fed chair Jerome Powell sought to squash speculation of rate cuts, stressing that policy needs to be “restrictive” and kept there “for some time”.

US central bankers are aggressively tightening policy as inflation remains stubbornly high. Most recent figures show that core CPI climbed 0.6% over August 2022, leaving it 6.3% higher than a year ago. Beyond the elevated level, of particular concern is the increasing breadth of inflationary pressures. By our estimates, just under four-fifths of the basket is increasing by 4% or more on a year-on-year basis.

And the red-hot labour market means there are clear risks that second round effects on wages and prices will cause inflation to become entrenched. The Fed’s best hope is that more American workers return to take the steam out of the labour market. But whilst the participation rate rose from 62.1% to 62.4% in August 2022, it still remains a full percentage point below its pre-pandemic level.

Chair Powell acknowledged this “supply side healing” had not brought down inflation, thereby necessitating further policy tightening. He added that he “wish[es] there were a painless way… to get inflation behind us” but warned “there isn’t”. Updated forecasts from the Fed showed a higher unemployment rate profile and weaker GDP growth. Even so, they fall short of projecting an outright recession despite the “dot plot” signalling rates will rise to 4.4% in 2022 and 4.6% in 2023 (i.e. 150 basis points of tightening).

It’s optimistic to think a recession can be avoided and in our opinion any chance of a soft landing has evaporated. We believe a recession will be needed to bring inflation under control (see, Forget soft landings – how much of a recession is needed to tame inflation?) and forecast the US economy to contract by around 1% in 2023.

Hiking rates to around 4% should be sufficient to do the job and there are signs tighter financial conditions are starting to have an impact. All but one of our six monetary recession indicators (10-year Treasury yield curve, Fed funds rate, real money base, real narrow money supply and real broad money supply) are flashing red.

Once the US economy is firmly in recession, we would not be surprised to see the focus of policymakers shift back to supporting growth. But any pivot is probably still a long way down the track. So long as inflation remains inconsistent with the Fed’s price stability mandate, it is clear that the committee will continue to raise rates until inflation is back under control.

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