The Fed’s 50-bps hike faces off against the “compressed lag effect”

In the final Fed meeting of the year, Chairman Powell and the FOMC announced a rate hike of 50 bps, lifting the policy rate to 4.25%-4.50%.

The decision was unanimous and very much in line with expectations and prevailing rhetoric.

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This marked the eighth consecutive meeting where monetary policy was tightened, although the magnitude of the hike was lowered from 75 bps (which was implemented through the previous four announcements).

The decision came shortly after the publication of CPI which was down at 7.1% YoY (a report of which interested readers can view here), compared to the previous month which registered a rise of 7.7%.

Although Jerome Powell did not appear to suggest that an additional 50-bps hike could be expected in the first meeting of 2023, the Fed’s planned tightening is far from complete, and the market will likely see a 25-bps increase during the next announcement.

The much-awaited dot plot shows an increase in target levels of interest rates from the September projections, with 2023 rising from 4.6% to 5.1%, 2024 increasing from 3.9% to 4.1%, and 2025 from 2.9% to 3.1%.

This increase in the terminal rate was above market expectations, and may well be the last card the Fed can play given the rising turmoil in real estate, underfunded pension holdings and other assets.

After the June CPI peaked at 9.1% (a report of which is available here) and triggered an extended period of frantic tightening, the Fed is left with very limited ability to revise its pathway further upwards without risking a blow to its credibility.

A couple of the members expect the policy rate to rise even above 5.5% in 2023, implying rate hikes into the summer, which would bring a halt to market liquidity and jeopardise credit markets.

Summary of economic projections

Firstly, inflation projections show that the Fed does not expect to see the 2% level materialize until at least 2025.

Worryingly, this implies that the monetary authorities are looking to keep rates elevated for the entirety of that period.

The chart below gives us a sense of the magnitude of the challenge that the Fed faces compared to historic tightening cycles.

Yet, Bank of America’s Head of Global Economic Research, Ethan Harris, expects that although achieving 3% – 4% inflation could be possible, the 2% target may well be out of reach even over a 2-3 year horizon. 

The Fed has painted itself into a corner on this issue, by continuing to steadfastly commit to its 2% target.

Arguably, there is nothing sacrosanct about this number, but having put this threshold on a pedestal for years, the FOMC has lost any flexibility to ease this constraint.

Secondly, the Fed has projected unemployment to reach a median level of 4.6% in 2023, and expects this to be maintained through 2024 whiles rates continue to be high.

This is highly optimistic given that the lagged effects of the Fed’s unprecedented tightening will come to bear, while rate hikes are expected to continue.

The Survey of Consumers published by the University of Michigan last month reinforced this concern by stating,

About 43% of consumers expected unemployment to rise in the year ahead, a share last exceeded at the start of the pandemic and before that in 2009.

Just as importantly, in another report by the University, 47% of the top third of earners are also looking to draw down spending over the next year in response to high inflation, which would prove catastrophic for job seekers in the coming quarters.

With reports of plenty of small business closures underway as well, non-college-educated and less-skilled workers will find it harder to secure work.

Monetary lags

Sharp turnarounds in some economic indicators are pointing to what Danielle DiMartino Booth, CEO and Chief Strategist at Quill Intelligence, as well as an advisor to the Dallas Fed from 2006 – 2015, has referred to as the,

…compressed lag effect.

This implies that the pace of tightening this year may have caught up with policymakers, and we could potentially see a faster deterioration in economic activity than in previous cycles.

The real estate sector is highly sensitive to interest rates and witnessed a surge in mortgage rates (which I covered here), as well as a sharp downturn in the Case-Shiller Index (discussed in an article on Invezz) reflecting the lack of buying appetite.

Short-term interest rates in the municipal bond market have shot up as well, a worrying omen of things to come, in one of the safest asset classes in the economy.

The annual percentage change in initial unemployment claims has suddenly turned positive, signalling that more trouble may be brewing in the labour market.

A Fed divided?

Although this decision was unanimous, as inflation levels ease, dovish members may fear that additional tightening could have catastrophic effects on crucial sectors including housing and auto, as well as on overall consumer spending.

The exit of James Bullard, President of the Federal Reserve Bank of St. Louis from the FOMC this year, may mean one less ally for the chairman’s tightening agenda.

Booth believes that things may get very tricky for the monetary body if well-known doves such as John C. Williams of the New York Fed, and Lael Brainard of the Board of Governors were to find new common ground in 2023.

Outlook

Markets will likely see a 25-bps hike during the first meeting of 2023.

Although the Fed has remained resolute, the introduction of potentially more dovish members via rotations, falling inflation expectations, ongoing demand destruction and unwinding of the jobs market will likely force the Fed to pause earlier than the current target.

At this juncture, the Fed is caught between a rock and a hard place, risking much higher unemployment due to over-tightening or else triggering further price instability in the event of easing.

In addition, if refinancing rates continue to rise, negative spillovers may drag down asset values in other markets as well.

It will be interesting to see whether the following dot plot shows a wider distribution, which would imply greater policy friction between the serving members and a strong likelihood of a pivot.