The Tightening Cycle Begins

Fed Begins Rate Hikes. More to Come

• As expected, the Fed raised the overnight target rate 25bps to 0.25% – 0.50%.

 

• The updated Dot Plot now shows a total of seven 25bps hikes in 2022, including today’s, and another three hikes in 2023 reaching 2.75%. The longer-run fed funds terminal rate is forecast to be 2.4%, reached in 2024. There was speculation that the terminal rate would be raised in recognition of the generationally high inflation numbers but it essentially remained unchanged (see Dot Plot below).

 

• The market was priced for seven hikes this year prior to the meeting and the Fed delivered. For some time now, the market has been pulling the Fed in its direction on rate hikes and this looks to be the case once again.

 

• While the word “transitory” may have been stricken from the Fed’s lexicon, they still expect inflation to move fairly quickly lower. For Core PCE, they see it ending 2022 at 4.1%, and down to 2.6% in 2023, and then to 2.3% in 2024. So, a fairly quick reversion to pre-pandemic levels is the forecast. We shall see.

 

• The Fed also has GDP heading back to pre-pandemic levels in short order. For this year, they see GDP growth of 2.8%, significantly down from the 4.0% they saw previously. For 2023, they have GDP at 2.2% and 2.0% in 2024. So, a quick return to pre-pandemic growth is the forecast.

 

• Not much specifics on the balance sheet other than that quantitative easing is over with a balance sheet just over $8 trillion. It’s expected that the balance sheet will be allowed to run-off beginning most likely in July, but no specifics as to how much was offered at today’s meeting. In his recent Capitol Hill testimony, Powell did mention shrinking the balance sheet will be a 3+ year process. If  you think it might return to a pre-pandemic level of $4 -$5 trillion, that would be around $1 trillion per year, with much of that from the MBS holdings.  Mortgage yield spreads have  been widening all year in anticipation of this shift by the Fed. How much more spread widening occurs when the actual drawdowns begin is something the Fed will closely monitor as will investors.

 

• The Fed forecast that the unemployment rate will bottom this year at 3.5% and stay there for the next coup years before ticking up to the long-run rate of 4.0%. Recall, 3.5% was the pre-pandemic low reading for unemployment. So, the Fed is certainly forecasting a labor market that returns to that prior strength and stays there for the next couple years.

 

• Overall, a hawkish meeting with seven hikes penciled in for this year versus just three hikes they had forecast back in December. An additional three hikes in 2023 would bring the fed funds rate to 2.75% before easing back to the long-run terminal rate of 2.50%. The significant markdown of GDP from 4.0% to 2.8% for this year is no doubt a reflection of the economic headwinds from the war in Ukraine and higher prices expected to eat into household budgets and limit discretionary purchases. Still, in the Fed’s current inflation-fighting mindset, that reduced growth rate is still well above the long-run potential of 2.0%, or so. That will keep the Fed firmly in rate hiking mode, despite the expected slowing in the economy.

 

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