Fed projections are less useful these days.
The sheer speed of this Federal Reserve rate-hike cycle has rendered its own predictions less meaningful, or at least less helpful, than usual.
Case in point is its Summary of Economic Projections (SEP). Released after Federal Open Market Committee (FOMC) meetings in March, June, September and December, it has become a significant means by which policymakers communicate their view of the path of the economy. The idea is that revealing their forecasts for gross domestic product, employment, inflation and the level of the federal funds rate will turn market expectations and investment decisions in the direction the Fed wants.
But projections are only worth something if they are believable. The SEPs have changed so drastically this year that they don’t offer the guidance they should, especially when it comes to the level at which Fed officials think interest rates must reach to tackle inflation.
In June, FOMC members collectively signaled that the fed funds rate would likely reach 3.4% by December. The new SEP released in September indicates they now think 4.4% more likely. That’s a shift of a full percentage point in the span of just three months—a tremendous increase in expectations. The jump is even more dramatic when you consider this figure was 1.9% in March. Likewise, the prediction for the highest level rates will reach before inflation falls—the terminal rate—has leapt from 2.8% to 3.8% to 4.6%.
On the one hand, it’s good to see policymakers reacting to the data rather than stubbornly holding onto a conceptual position, as they did last year by sitting idle while prices climbed. On the other hand, the rapid shift in projections suggests they don’t have a firm grasp on what’s happening. Realizing they are behind the curve, they appear to be sprinting to catch up rather than truly offering much guidance.
It’s telling that Powell revealed after the September FOMC meeting that, “We have always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging.” It seems that “always” only goes back a few months.
To our thinking, prudent investors can’t rely on Fed forecasts now as they are accustomed to doing. This is why we at Federated Hermes, like most asset managers, do our own research and make our own calls on macroeconomic trends, monetary policy and the like. On rates, we have been more pessimistic than the Fed this year, expecting a terminal rate higher than the SEP. But that’s reversed recently as we expect a lower number of around 4.3%. That’s not a big difference, but it reflects our view that the Fed will quite possibly overshoot and push the economy into a recession—or “a sustained period of below-trend growth,” as Powell puts it.
To that end we continue to invest defensively, keeping our Weighted Average Maturity targets short to capture the rising rates while avoiding longer-dated securities unless they are floaters. Our prime money funds are targeting a 15-25 day range, with our government and municipal products slightly longer at 25-35 days. Even as yields across the liquidity industry have risen, the front end of the Treasury curve remains anchored in the ongoing safe haven trade, and the Fed’s doubling of the amount of securities rolling off its balance sheet monthly (now $60 billion in Treasuries and $35 billion in mortgage-backed securities) hasn’t changed the market noticeably.