Fed hikes and finds a plateau…maybe

The Federal Open Market Committee (FOMC) of the Federal Reserve hiked rates yet again this week, bringing their target for the federal funds rate to a range of 5%–5.25%. This is the tenth consecutive meeting with a hike and the cumulative increase of 5% in just more than a year is the most aggressive tightening campaign in four decades. But there was an important change in the FOMC’s stance that was reinforced by Chair Powell’s press conference: It no longer anticipates more rate hikes. The FOMC has moved to a new stage where it does not have a hiking bias and will evaluate the need for more tightening as the economy evolves. The committee could even reduce rates if inflation surprises to the downside of its forecasts. Although the hikes are most likely done, in our view, we are not ready to move to a bullish stance as we expect a mild recession in late 2023.

Mission accomplished(?)

The FOMC made an important shift in stance, in that it no longer has a bias toward additional rate hikes. This was made clear in the official statement and Powell reinforced that message throughout the press conference. Over the course of the past year of rate hikes, the official meeting statement signaled “ongoing increases” were anticipated, with only a slight change six weeks ago to an expectation of “additional policy firming.” This week, the FOMC removed the reference to anticipated rate changes. Powell reinforced that message in his opening statement and also, when responding to a question, referred to the removal of that language as a “meaningful change” in the committee’s stance.

Moreover, the language for achieving a desired level of monetary tightness changed from being a desired future state (over the past year) to a goal that has now been achieved. Instead of talking about what needed to be done “in order to attain” a level of rates to get inflation under control, this week Powell described it in the past tense: “We have raised interest rates by a total of five percentage points in order to attain” [emphasis added] the conditions needed to bring inflation back down. This phrasing makes it clear the FOMC has now reached a level it thinks is good for now, so long as the economy and inflation play out as it expects.

Figure 1: Federal funds rate and projections (%, top of target range)

Data as of May 4, 2023. Sources: Bloomberg, Federal Reserve, WTIA.

It can go either way from here

The bigger question is whether the FOMC keeps rates at this current level through the end of 2023 as it currently expects, or if the economy deviates substantially enough from its expectation that the committee ends up hiking more or even cutting rates. It could go either way. Forecasting the economy and inflation is a tough game, and in the 11 full calendar years the FOMC has been publishing projected rate paths (the “dot plot”), the committee has only been correct in five of them. Put a different way: If history is any guide, the FOMC has a higher chance of being wrong than it does being right about its year-end projection of 5.0%–5.25%. The only trouble is knowing which way it will break. While either is certainly possible, we think there is a greater chance of rate cuts by year end than a restart of hikes, based on our outlook as well as the FOMC’s.

We expect Consumer Price Index (CPI) inflation to fall to 3.3% in just the next three months and then to 3% in December and lower thereafter (Figure 2). The FOMC projects a different measure of inflation—the Personal Consumption Expenditures (PCE) price index—and uses quarterly values. The median FOMC member is projecting 3.3% y/y in 4Q 2023. Adjusting for the differences in the two measures, our comparable forecast would be a half-percent lower of 2.8% at year end. If that were to transpire along with our expectation of a mild recession later this year, the FOMC is likely to cut rates. We do not rule out the possibility that inflation could surprise to the upside in coming months leading to more rate hikes, but we do not expect that.

Figure 2: Consumer Price Index (CPI) inflation (% change, y/y)

Data as of April 12, 2023. Sources: Bureau of Labor Statistics, WTIA.

Focus on bank lending and financial conditions

Powell put a special focus on bank lending conditions going forward. It’s not a surprise the current stress in the banking system would be a consideration, as the FOMC noted at its previous meeting that was held just 12 days after the failure of Silicon Valley Bank. Nevertheless, Powell’s indication that it would be “a particular focus” going forward made clear the issue has taken center stage for the committee, as well it should. We fully expect small and regional banks to rein in lending activity which will suppress growth, increasing the probability we have a mild recession this year.

More generally, financial conditions have tightened substantially over the course of the rate hike cycle. In our view, the level needed to suppress inflation was likely reached several months ago. As of this week, the FOMC agrees, and Powell pithily stated as “policy is tight.” Our favored aggregate measure of financial conditions is the National Financial Conditions Index (NFCI) which aggregates 105 individual measures into a single metric in three categories: credit, risk, and leverage.

The overall index has tightened appreciably since a recent low in late-2021, but the individual behaviors of the three subcategory indices are of more interest.[1] In particular, the leverage subindex has in recent weeks risen substantially and is now nearing the highest level recorded during the COVID pandemic (Figure 3). Of note, the leverage measure is shown to be a leading indicator of financial stress while the risk and credit measures are coincident and lagging indicators, respectively. The heightened readings for leverage are likely giving the FOMC a reason to be cautious about future hikes and are also a signal to us of risk in the markets ahead.

Figure 3: National Financial Conditions Index Subcomponents

Data as of May 3, 2023. Sources: Bloomberg, Federal Reserve Bank of Chicago, WTIA.

Core narrative

The FOMC raised its target for the federal funds rate again this week making it the tenth consecutive meeting and a cumulative 5% increase since the start of its campaign. Importantly, the FOMC does not have an anticipation of more increases at future meetings, marking a new phase for monetary policy. But nothing is assured, and if inflation reignites unexpectedly, the committee is quite willing to respond with even more tightening. But a reliance on the path of inflation also means the FOMC could cut rates later this year if it decelerates more quickly than it expects. We think there is a higher chance it cuts rates, but that does not mean we are eager to load up on risk. The cumulative impact of rate hikes and the turmoil in the banking sector both lead us to expect a mild recession in the second half of 2023. Accordingly, we hold an underweight to risk assets in client portfolios, including to U.S. small-cap equities.

[1] The Leverage subindex components are generally measures of debt relative to equity. The Credit subindex are measures of household and nonfinancial business credit conditions. The Risk subindex captures volatility and funding risk in the financials sector.

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