INSIGHTS

On September 22, 2022

The Fed is Not Done

The Federal Reserve (Fed) announced a third consecutive 75 basis point (bps) rate hike, bringing the fed funds rate to 3% to 3.25% and continued to set a hawkish tone, raising its “dot plot” and inflation forecasts, while reducing its growth and unemployment outlook.

We believe investors should be prepared for a period of higher rates for longer, as inflation makes its slow journey back to the Fed’s target. We see recession risks as still finely balanced, and believe credit investors need to be diligent, cautious, and ready for volatility.

The new “dot-plot” implies no rate cuts next year

The Fed raised its “dot plot” projections for future rates again (Figure 1) and now projects policy rates at 4.375% by year-end (up 88bps from the projection in June and 188bps higher than in March).

Figure 1: The Fed once again raised its future rate forecasts

Source: Federal Reserve, September 2022

This implies another 125bps of hikes for the rest of the year, perhaps 75bps hike at the next meeting in November and another 50bps in December.

Contrary to market pricing, the Fed projects no rate cuts next year, which is in line with our view. Rate cuts are implied by 2024, but only as far as 3.875% from 4.625%, suggesting higher rates for longer.

The Fed seems to be hyper-focused on inflation at the expense of growth

The Fed now projects inflation — as measure by the Personal Consumption Expenditures (PCE) Index — at 5.4% by year-end (up from its 5.2% projection in June). It also expects core PCE to remain above the 2% target through 2025.

Given the impact of its rate hikes, the Fed materially cut its growth forecasts for 2022 and 2023 to 0.2% and 1.2% from 1.7% and 1.7%, respectively. It also projected unemployment could rise to 4.4% by the end of next year from 3.7% today.

After two decades of being hyper-focused on its growth mandate (at the expense of inflation risks), it appears the tables have turned, with the Fed now pursuing inflation at the expense of growth.

This is reflected by the so-called “misery index,” which adds inflation (as measured by the Consumer Price Index [CPI]) to the unemployment rate. It is currently as high as it was during the 2008 recession. However, the composition was very different in 2008, as it was mostly driven by high unemployment, unlike today, where inflation is the dominant element (Figure 2). Powell stated the Fed is “strongly committed” to restore 2% inflation and the “economy does not work” without price stability.

Figure 2: The “Misery Index” is at 2008 levels but inflation, not growth, is the problem

 Source: Bureau of Labor Statistics, Insight, September 2022

The Fed is making progress, so rate hikes will likely slow into 2023

At its previous meeting, we commented that the Fed’s “game plan” was to start slowing the pace of hikes. However, as hinted at Jackson Hole last month, inflation has been too persistent, now thanks to “sticky” service categories like rent and healthcare (Figure 3). We believe the Fed will need to see core CPI begin to roll over, before feeling comfortable that its policy is working. This has yet to occur, and given the transmission lag of monetary policy changes, it may take some time.

Figure 3: Core CPI is still anchored above 6%, leaving the Fed a long way to go

 Source: Bureau of Labor Statistics, Insight, September 2022

Nonetheless, we expect the Fed will soon slow its pace of hikes into 2023. Rates are now above the Fed’s estimate of “neutral”, implying smaller hikes will have a bigger impact. The Fed is now quickly catching up to the “Taylor Rule”-implied policy rate (Figure 4) and is on track to surpass it this year. Further, headline inflation is at least now decelerating.

Figure 4: The Fed’s policy is catching up to the Taylor Rule

 Source: Insight, Federal Reserve, Bureau of Labor Statistics, Bureau of Economic Analysis, September 2022

The more hawkish the Fed gets, the more careful investors should be

Last meeting, Fed Chair Jay Powell called a 75bp hike “unusually large,” but these unusual economic times have made them more normal.

This is certainly new territory for this generation of investors. Given a four-decade trend of falling rates on a secular basis, this hike raised the Fed Funds rate above its peak from its previous hiking cycle (in December 2018). This the first time this has happened since 2000 (when rates rose slightly more than they did in the mid-90s). However, it is clear to us that the Fed is not done.

The more hawkish the Fed gets, the more likely market volatility is to be elevated, and the risk of a recession ticks higher. We expect this to keep the Treasury yield curve inverted, which is why we forecast a 10-year yield of 3.6% in a year’s time. Until there is more tangible progress on the inflation front, we believe credit investors need to stay cautious and focus on robust security selection.

CRN: 2022-0922-10353 R

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

The Consumer Price Index (CPI) is released by the Bureau of Labor Statistics as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

The Personal Consumption Expenditures price index (PCE) issued by the Bureau of Economic Analysis is similar to the CPI which focuses on consumer prices, however PCE is the primary inflation index used by the U.S. Federal Reserve when making monetary policy decisions.

The “dot plot” illustrates the Federal Reserve’s predicted interest rate outlook.

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 September 21, 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.