In this tightening cycle the Fed was late to start and has been playing catch up ever since.
Now the market fear is that they will overdo it: the more hawkish members of the FOMC want to push rates up towards 4% sooner rather than later, citing in particular the risk that inflation expectations would become unanchored from the Fed’s medium-term target of 2% for the PCE deflator measure of inflation.
At the last FOMC meeting the hawks seemed to have won the argument, and futures markets (briefly) priced in a peak FF rate of 4% for mid-2023. Not quite what the hawks were asking for but very much in their spirit. Chairman Powell sounded confident that the economy was robust enough to stand the pain without tipping into recession.
But looking forwards rather than backwards it’s clear that US growth momentum is slowing very fast, and so are the leading indicators of inflation. On the growth side, consumer confidence is at record lows, housing transactions have slumped, and both ISM and the Markit PMI new orders series for manufacturing have fallen below 50. Indeed, the consensus among economists is that the economy is already slipping into a (mild) recession. On the inflation side, commodity prices are 20-40% down from their recent highs and 10-year break-evens have fallen back from 3% to 2.3-2.4%, which is fully in line with the Fed’s inflation long run objectives. No sign of un-anchoring there.
In that context, here is an interesting fact. Over the past 50 years or so, the Fed has only twice continued tightening/raising rates after ISM new orders fell below 50. That was under Paul Volcker – in 1979, and again (very briefly in 1982). But in1979 we had had a decade of stagflation and there was really no other choice but to risk a (severe) recession to bring inflation under control.
At next week’s FOMC meeting they will do it for a third time and likely raise the FF target by 75 basis points, finally taking rates to where our Taylor Rule has long suggested rates needed to be several months ago. Markets now expect further hikes after July, taking the FF funds target up to 3 ¼ to 3 ½ percent by early-next year before policy rates start declining again.
But do we really need another Volker moment?
Probably not in our view, and we think the way the data is going that you can’t rule out the possibility that the Fed pauses in October – or perhaps even in September.