INSIGHTS

On June 17, 2022

Can the Fed Stick the Landing?

As heavily signaled over the last couple of days, last week's Consumer Price Index (CPI) report was enough for the Federal Reserve (Fed) to hike rates by 75bps (basis points) instead of 50bps — the largest move since 1994, to 1.5–1.75%.

We believe a sharper hiking cycle will help the Fed from falling far behind the curve, but risks of a hard landing are modestly higher. Although we see opportunities for fixed income investors, continued volatility is inevitable, and investing requires diligence and care (as it always does).

Inflation is now an urgent priority for the Fed

Chairman Jay Powell used his June 15 press conference to reinforce the Fed’s focus on inflation and its intention to adjust policy in line with data releases. At present, we think inflation is controlling Fed policy rather than vice versa.

The new “dot plot” was revised sharply higher, with the median projection approaching 4% for end-2023, from less than 3% at the previous meeting (Figure 1).

Figure 1: The Fed’s “dot plot” shows future rate expectations moved sharply higher again

Source: Federal Reserve, June 2022. The "dot plot" shows projections for the federal funds rate. Each dot represents the median "dot" or projection of the Fed policy makers for the rate's target range at the end of each year shown.

As such, we see another 75bps hike in July as being very much in-the-cards, and we also currently expect 50bps in September. We see hikes at every meeting thereafter into mid-2023 as likely, generally at 25bps in magnitude, taking rates up to approximately 3.75%, around the Fed’s current projection for terminal rates.

The Fed also raised its inflation forecast to 5.2% from 4.3% for end-2022, but slightly lowered its end-2023 forecast to 2.6% from 2.7%, implying above-target inflation to persist beyond the next 18 months, in line with our own views. The Fed’s GDP forecast is 1.7% for each of the next two years, down from 2.8% and 2.2%, indicating that it does expect its policy to slow growth.

The Fed is catching up to Taylor Rule-implied policy rates

The Fed has been tightening more slowly than the optimal policy rate implied by the Taylor Rule, however, with its latest hike, the Fed seems to be making up ground (Figure 2).

Figure 2: Fed policy is now catching up to optimal policy rates as implied by the Taylor Rule

Source: FRED, Insight calculations and projections, June 2022. The Taylor Rule is an econometric model that describes the relationship between Federal Reserve operating targets and the rates of inflation and gross domestic product growth.

We expect the Fed’s policy to converge to Taylor Rule-implied policy rates by early 2023, assuming its inflation projections broadly play out. The Fed could even overshoot it as it attempts to restrain growth.

Targeting the prized “soft landing”

The Fed’s greatest challenge is to slow growth but avoid a recession — the much-vaunted “soft landing.”

The good news is that pandemic-era fiscal stimulus has pushed Gross Domestic Income (GDI — a slightly different measure to GDP measuring income-related metrics) to approximately 1.5% above the pre-pandemic trend (Figure 3).

Figure 3: Gross domestic income running above the pre-pandemic trend may be a source of inflation

Source: FRED, Insight calculations, June 2022

As such, if the Fed engineers two years of near 1% growth, it would bring GDI back to trend — implying a successful soft landing. We believe a Fed funds rate in the 3.5–4% area — or about 1% above “neutral” — could provide sufficient tightening.

Recession risks have modestly increased

The primary risk, however, is that abrupt tightening, negative disposable incomes, and financial market headwinds could create feedback effects that slow economic activity further.

“Overtightening” is also a risk, as it takes time for the Fed policy changes to take effect, making it tough to judge when it goes a rate hike too far. Larger hikes carry the greater risk of a more damaging overshoot.

Therefore, we now see the odds of recession in the next 18 months at close to 50/50.

Volatility is inevitable as markets adjust to rising rates

As we discuss soft and hard landings and 1980s-like inflation, it is only fitting that a sequel to Top Gun is dominating the box office. Landing the economy may be harder than landing a fighter jet, but we believe a soft landing is still possible as federal fiscal stimulus fades and strong corporate and consumer balance sheets offer a potential airbag.

However, volatility is likely to remain quite high given the uncertainties, so the ride will likely be turbulent. Although we see opportunities to enter the credit markets, we believe care, diligence, and rigorous security selection will be increasingly essential.

CRN: 2022-0613-10106 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management. 

Please note: any forecasts or opinions expressed herein are Insight Investment's own as of June 15, 2022 and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.