Our fixed income team expects official US interest rates to rise higher than markets are pricing. We see the benchmark fed funds rate potentially ending 2023 at 2.5% or higher – a full percentage point more than currently discounted in market expectations.
Our fixed income team believes that projections for policy rates presented by the Federal Reserve in December do not align with its own growth, inflation and unemployment rate forecasts.
The median projection of Fed board members and Federal Reserve Bank presidents is that the policy rate will be at 2.1% by late 2024, while the unemployment rate is estimated to be 3.5% by then, with core inflation at 2.1%, just slightly above the Fed’s 2% target after three years of overshoot.
At the latest count, the jobless rate stood at 3.9% in the US and inflation at 5.7%. [1]
En route to a period of persistent inflation?
While labour market tightness in the US is becoming apparent in wage metrics, inflation has proved stickier than expected. Used vehicle prices have surged again, while new vehicle prices continue to rise steadily. Global supply-side disruptions could last for many months. Moreover, inflation is spreading beyond core goods to services.
If workers have accrued more wage bargaining power in a tight market, wage costs could be a source of ongoing input cost pressures, maintaining support for inflation. Alongside higher shelter costs, the result could be a period of persistent, cyclical inflation strength.
Moving from accommodative to restrictive
To close the gap between the policy rate forecast and the inflationary pressures that we foresee in the US, we see the policy-setting FOMC potentially raising rates at each of its seven meetings in 2022.
With the US economy near full employment, and inflation at least in part driven higher by cyclical and structural forces, we believe the central bank will need to adopt a more restrictive stance to counter higher inflation.
Policy tightening can be achieved by either raising official rates to significantly above the 2.5% ‘neutral’ rate and/or via a more rapid reduction in the Fed’s balance sheet, which has ballooned as a result of its pandemic-era asset buying to support the US economy.
We expect the FOMC to start raising rates at its March meeting, and cease reinvesting coupons and maturing securities on the Fed’s balance sheet in June. If, as we expect, rates are raised at every meeting in 2022 and 2023, they would reach 2.5% by end-2023. By comparison, market pricing suggests policy rates will peak at only around 1.6% in late 2024.
Policy normalisation on two fronts
One key distinction in this tightening cycle versus earlier ones is that the Fed is likely to normalise policy rates and the level of its balance sheet more or less simultaneously. The main reason for this is that its now ultra-accommodative policy stance needs to be adjusted faster.
There appears to be room to do so as US economic growth is still above trend thanks to generous stimulus from the administration following the Covid lockdowns. Household balance sheets are generally strong, corporate earnings have boomed, and the economy is close to full employment.
[1] Personal consumer expenditure price index, the Fed’s preferred inflation measure; source Personal Income and Outlays, November 2021 | U.S. Bureau of Economic Analysis (BEA)
