Fed sends warning to markets on easier conditions

‘Important that financial conditions reflect policy restraint’

The Fed's policy statement was almost a carbon copy of that from November, while the quarterly update to the projections showed a significant downgrade to the 2023 GDP growth forecast (to 0.5% Q4/Q4 – now in line with our own forecast), and much smaller upgrades to inflation forecasts than at recent projections rounds – reflecting that inflation is finally now moving lower in line with forecasts. The Committee now also projects a somewhat higher peak in rates, at c.5% (previously around 4.5%); this projection is the year-end forecast, although Chair Powell confirmed in the press conference that this is indeed where the FOMC currently sees the actual peak (which is consistent with Fed communication that rate cuts next year are unlikely).

Easing financial conditions could prompt the Fed to do more

Most interesting to us was the carefully worded comment on financial conditions, which featured in Chair Powell’s introductory statement at the press conference, and which he was immediately pressed to elaborate on in the Q&A. Powell explained that, while the Fed’s policy tool is changes to the fed funds rate, this is transmitted through the economy via financial conditions, and though persistent moves are more important than short-term moves, the Committee sees it as ‘important that financial conditions reflect the policy restraint we’re putting in place to get inflation to 2%’. This to us was a warning to financial markets, probably in light of the recent soft inflation readings, that if conditions were to ease too rapidly that the Fed may ultimately have to do more for its part in terms of raising rates. While we currently expect the Fed to downshift to 25bp hikes at the coming two meetings, and to pause once the upper bound of the fed funds rate reaches 5%, a persistent easing in financial conditions (significant further declines in bond yields and/or a strong equity market rally) could indeed mean that the Fed ultimately goes further if it judges that financial conditions are no longer sufficiently tight.

When might the Fed be more comfortable with such an easing in conditions?

While we hold a counter consensus call for a total of 125bp in rate cuts late next year, we think we are still some months away from a point where the Fed would be comfortable with a major easing in financial conditions – likely not until late Q2 or Q3, assuming our base case for inflation and unemployment pans out. Inflation has begun its long trend downward, but some residual upside risk on the services side will likely persist even into the second half of 2023, and we will need to see a substantial loss of momentum in the labour market to really convince the Fed that the inflation genie has been put back in the bottle. For more on how we see monetary policy and the US economy evolving in 2023, please see our Global Outlook publication.