A 100 basis point rate hike, as whispered by some in the market, seems unrealistic to us given the risk of being perceived as panicking.
The Fed meeting is expected to be heavily influenced by the August CPI inflation report, which showed an uncomfortable persistence of underlying inflationary pressures (core CPI index at 6.3% yoy). It is very likely that the Fed will hike rates a third time by 75 basis points to a peak of 3.25%. With this new rise, it will be the strongest six-month sliding rate hike since 1981 under the Volcker era.
A hike of 100 basis points, as whispered by some in the market, seems to us rather unrealistic and therefore counterproductive given the risk of being perceived as panicking.
The Fed continues to focus on past data, particularly the inflation and employment duo, rather than the economic outlook, which continues to darken. The market consensus for GDP growth in 2023 has recently slipped below 1% and we believe it is only a matter of weeks before it hits zero.
The trend at the Fed (and elsewhere) is to distance itself from traditional economic models, even if certain indicators, such as the market-expected 5-year inflation (“Fed 5-year 5-year, only 2.12%) , could have warned of the growing risk of monetary policy mistakes. The long latent effect of monetary policy on the economy, although briefly mentioned as a risk at the July meeting, should remain unsaid this time.
Our concern is the pace of rate hikes in a post-COVID very high aggregate debt environment. The American consumer, although bolstered by the COVID budgetary measures, has recently resumed excessive use of the credit card, a sign of weakness to watch. The real estate market has been severely weakened and is having a major impact on the economy, while the high-yield bond market, which we believe is the real lifeblood of the American economy, has been hogged for several months between rate hikes and the massive “quantitative tightening” liquidity pull.
Guidance for the next meeting in early November, a few days before the midterm elections, is likely to remain vague as the Fed does not prohibit a downside modulation of the next rate hike, which we think should happen this time given the economic slowdown and downward pressure on commodities.
The key message should echo Jackson Hole’s words: inflation remains too high and it’s time for tightening, a modulation of hikes that shouldn’t mean an end to tightening. It is also time for firmness in a very emotional political context on inflation a few weeks before the midterms.
Important point of the September meeting: the new macroeconomic and interest rate projections. After the 75 basis point hike, the Fed is likely to revise higher through late 2022 and early 2023, with a “top” Fed landing zone possibly around 4.25% (vs. 3.75% in the June forecast). halfway between money market prices and lower economist expectations. President Powell should warn that once that rate is reached, it should not budge to prevent a resurgence of inflation.
For the bond market, the eye will be on the famous neutral or equilibrium rate. Small consolation for those looking for “dovish” signals, it is very likely that the Fed will keep this at 2.5%, probably because productivity numbers remain disappointing, but also because the Fed is on the post-COVID thesis Unconvinced is structural inflation recovery: The Fed is expected to hint at a return to the sacrosanct 2% PCE inflation in 2025. All’s well that ends well, so Fed stories often end well.
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