Don't fight this Fed
Higher, sooner and longer for these hawkish policymakers.
Federal Reserve Chair Jerome Powell could not have been clearer at the central bank’s annual monetary policy symposium at Jackson Hole, Wyo. While inflation has improved in recent months, it remains elevated, with energy and food prices poised to bounce higher. After hiking interest rates by a quarter point in March and by a half point in May, the Fed drove them higher by 75 basis points in each of June and July, a pace we think is similarly appropriate for their upcoming September 21 policy-setting meeting.
Even with a possible downshifting to a pair of half-point rate hikes at the November and December meetings, the fed funds rate could peak at 4% by year-end. Moreover, starting this month, the Fed began to accelerate the passive shrinkage of its bloated $9 trillion balance sheet. It doubled the pace to $95 billion monthly ($60 billion in Treasuries and $35 billion in mortgage-backed securities, or MBS). The longer-term plan is to pare the balance sheet by a third over the next three years (absent a recession), which would effectively add another quarter-point rate hike each year.
Economy starting to slow As the Fed attempts to manage the Phillips Curve trade-off between engineering slower inflation but accepting an increase in unemployment, we’ve already begun to see the fruits of its labor. The housing market has slowed sharply this year as mortgage rates have doubled, manufacturing activity began to decelerate this summer and the labor market has shown signs of stress beneath the surface over the past six months.
Is a recession brewing? With two negative GDP quarters in the bank from the first half of this year and our view that we are likely so see a few more negative prints in coming quarters, the risk that the economy is on a glide path into recession sometime in 2023 is growing. From its 61-year record high in February 2022, the Leading Economic Indicators have declined in each of the last five months. Benchmark 10-year Treasury yields have risen from 2.50% a month ago to 3.32% today (perhaps on their way to 3.50% in coming weeks) reflecting additional tightening. With a modest quarter-point 2/10 yield-curve inversion, the bond market is anticipating that slower economic and corporate profit growth could bleed into an eventual recession.
Another dead-cat bounce? After a 19% rally from mid-June to mid-August, stocks corrected by 10% over the past three weeks, before this week’s 4% counter-trend pop. But we do not think we’re completely out of the woods, as the global food and energy markets have a number of challenges to hurdle in coming months due to the ongoing Russia/Ukraine conflict and the Biden administration’s energy policies, which could result in sharply higher prices.
Five interrelated issues: First, Europe has erected artificial price caps on Russian crude oil, but Russia will simply sell its crude at higher prices to India and China instead. In addition, Russia has threatened to violate the safe shipment of Ukrainian grain to global markets. Next, Russia’s Gazprom has weaponized their natural gas exports and shut down its Nord Stream 1 pipeline to Europe ahead of the winter heating season. Third, OPEC-Plus (of which Russia is a member) has reduced oil production by 100,000 barrels per day, despite recent pleas by President Biden to increase their production. Fourth, President Biden is reducing our Strategic Petroleum Reserve (SPR) to half by the end of October to about 388 million barrels. But 2022 is only the third time in the past 70 years in which we did not have a named hurricane in the U.S. by the end of August. Future storms in September and October could damage key refining capacity in the Gulf of Mexico, and the SPR may not be there as an intended safety net to support our energy needs. Finally, President Biden has issued the fewest leases for drilling of any president in the post-war era, according to the Wall Street Journal. This inhibits our energy self-sufficiency at a time when the U.S. and our European allies critically need our increased energy production.
Tweaking our GDP estimates The equity, fixed-income and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met late last week to discuss the Fed’s efforts to reduce inflation, and the impact that may have on the labor market and economic growth:
- GDP growth in the third quarter of 2022 will be flashed on October 27. We expect the Fed to continue aggressively hiking interest rates by another 75 basis points at its September meeting. With inflation still elevated, Back-to-School spending is running at half of last year’s pace, but it’s still relatively strong. So we raised our third quarter estimate from -0.2% to 0.6%. The Blue Chip consensus lowered its estimate from 1.7% to 1.2% (in a range of -0.3% to 2.7%) versus a positively revised decline of -0.6% in the second quarter.
- We still expect the Fed to slow its pace of rate hikes in November and December to a pair of half-point increases. So Christmas spending could slow to less than half of last year’s strong season. We left our GDP estimate unchanged in the fourth quarter of 2022 at 0.1%. The Blue Chip consensus cut its estimate from 1.4% to 0.9% (in a range of -0.9% to 2.2%).
- We reduced our full-year 2022 GDP estimate from 1.7% to 1.5%. The Blue Chip lowered its forecast from 2.0% to 1.5% (within a range of 1.0% to 1.9%).
- We reduced our full-year 2022 forecast for core CPI inflation from 5.6% to 5.4% (compared with an actual 5.9% in July 2022), and we left unchanged our full-year 2022 forecast for core PCE inflation at 4.8% (compared with an actual 4.6% in July 2022).
- We initiated our first quarter of 2023 GDP estimate at -0.7%. The Blue Chip consensus is at a gain of 0.6% (within a range of -1.4% to a gain of 2%).
- We initiated our second quarter of 2023 GDP estimate at -0.9%. The Blue Chip consensus is at a gain of 0.7% (within a range of -1.7% to a gain of 2%).
- We initiated our third quarter of 2023 GDP estimate at a gain of 0.5%. The Blue Chip consensus is at a gain of 1.1% (within a range of -0.8% to a gain of 2.7%).
- We initiated our fourth quarter of 2023 GDP estimate at a gain of 0.5%. The Blue Chip consensus is at a gain of 1.6% (within a range of 0.3% to 2.8%).
- We reduced our full-year 2023 GDP estimate from 0.6% to -0.2%. The Blue Chip consensus cut their estimate from 1.1% to 0.7% (within a range of -0.9% to a gain of 1.8%).
- We reduced our full-year 2023 forecast for core CPI inflation from 4.1% to 3.9% and for core PCE inflation from 3.6% to 3.3%.
Happy Anniversary, Elise!