Raising our Fed and ECB rate hike forecasts

Fed View: Upper bound of fed funds rate to peak at 4%

Unexpectedly persistent demand, and the inflationary pressure this is fueling, has led us to make a further upward revision to our outlook for Fed policy. Following the 50bp expected hikes in June and July – already well flagged to markets by FOMC members – we now expect the Fed to continue raising rates at this pace, with the fed funds rate now expected to rise to 3.75-4.00% by February. This level in the fed funds rate would be well above the previous peak in 2018, and the highest rates have been since the eve of the global financial crisis in 2008. Previously, we expected the Fed to slow rate hikes to a 25bp pace from September, with the funds rate peaking at 2.50-2.75% in December. Following this now much steeper rise in rates, our new base case also assumes the Fed already begins easing policy in 25bp steps in the second half of next year, as underlying growth momentum slows to near stagnation levels, and inflation comes within striking distance of the Fed’s 2% target. This would take the fed funds rate back to 2.75-3.00% by end-2023. While an unusual profile compared to recent rate cycles, this is more consistent with the kind of cycles we saw in previous high inflation episodes of the 1970s and 1980s, and reflects the fact that the nominal neutral rate moves up and down in line with inflation (see below). The risks to our new view are many and significant, reflecting the highly unusual degree of uncertainty in the macro outlook at present. Below, we outline the reasons for our view change, and will communicate in more detail on the broader macro and rates implications next week.

Why are we changing our view?

There are three primary reasons for our view change: 1) Persistently strong demand; 2) Persistently elevated inflation; 3) A more hawkish Fed reaction function.

1. Demand is not cooling by itself – As explained in our note last week, upside surprises and upward revisions to consumption data suggest that, despite the significant hit to real incomes from high inflation, consumers are not paring back spending on goods as much as we expected. Instead, they are leaning on excess savings from the pandemic and taking on more debt to continue consuming goods at a rate that is well above the pre-pandemic trend. In contrast to the eurozone, where inflation is largely supply-side driven, this excess demand is one of the primary reasons inflation is so high in the US. While we still expect some cooling in consumption growth in the US, it has become clear that this is taking longer and requires a more forceful policy response to trigger it.

2. Monthly inflation to stay exceptionally high over the coming months – We expect month-on-month inflation readings to remain at levels far in excess of the Fed’s target over the coming months, at least until September/October, and even after that core inflation is likely to remain well above 2% on an annualised basis. Headline inflation will remain high as utility providers pass on higher natural gas prices to consumers, while a shortage of refining capacity is raising the margin between oil and gasoline prices. Food price inflation likely also has further to run given the continued rise in input costs. For core inflation, the structural supply-demand imbalance in housing combined with strong household balance sheets is likely to keep upward pressure on rents. While the housing market looks to be in the early stages of turning, it will take a long time for this to lead to any cooling in housing rents. Meanwhile, services inflation will see continued upward pressure from wage growth and other pipeline pressures. In sum, inflation is unlikely to fall back to anywhere near enough necessary over the coming months to convince the Fed that its job is done, and our base case assumes we will not get to that stage until Q2 2023.

3. Fed is clear that price stability is its primary goal – While the Fed has a dual mandate of both price stability and full employment, Chair Powell has been clear that you cannot have a strong labour market without low and stable inflation. In this, his tacit admission is that even if unemployment were to rise – as we expect next year – the Fed would still prioritise getting inflation back to its 2% target. This determination to fight inflation has been echoed by other FOMC members, with board member Christopher Waller recently stating “I support tightening policy by another 50 basis points for several meetings,” and “In particular, I am not taking 50 basis-point hikes off the table until I see inflation coming down closer to our 2% target.” While one of the more hawkish members of the Committee, this last point if anything suggests risks are still to the upside on our new Fed call.

Risks to our view are many and significant

Inflation could stay more persistently strong if wage growth reaccelerates, given the extraordinary tightness in the labour market. Inflation could also fall back more rapidly if the economy slows more quickly than expected. There are also risks to our understanding of the Fed’s reaction function. So far, the Committee has communicated a more modest rise in rates than in our new base case. Commentary from former FOMC members such as Bill Dudley has indicated that the Fed may hike by even more than in our new base case if, for instance, we calculate real neutral rates using actual or near-term projected core inflation (4-5%) rather than longer run market-based inflation expectations (c.2.7%). Using 6-month ahead projected core inflation, we estimate the Fed would need to hike rates to 4.5-5% just to get to a neutral policy stance. That would be even higher if the Fed wanted to make policy restrictive. Should the Fed be preparing to go down such a path, it could use next week’s update to the dots projections to signal this to financial markets.

Will all of this tightening cause a recession?

As indicated at the beginning, we are currently reviewing our macro projections in light of the change to our policy rate projections. Broadly, we expect to downgrade our growth forecasts, and to raise our unemployment forecasts. We do not expect to forecast a recession at this stage, given the many offsetting factors outlined in our recent Global Monthly, and the fact that the supply side still has a long way to recover. However, we do expect underlying demand (consumption and investment) to weaken significantly, and this would raise the risk of recession. (Bill Diviney)

ECB View: Deposit rate seen reaching 0.75% early next year

We have also raised our forecasts for the ECB’s main policy rate. We now expect five 25bp increases, in successive meetings from July, taking the deposit rate to 0.75% at the ECB’s February 2023 meeting. We previously expected two 25bp hikes in July and September, so this represents a significant change of view.

What are the key factors behind the change?

First, inflation has continued to accelerate beyond expectations. Even though the evidence suggests that the vast majority is driven by supply-side imported inflation and to some extent post-lockdown catch up, it still creates challenges for the ECB. Most importantly, there is a concern that continued high rates of inflation will dislodge inflation expectations, especially given the possibility that supply-side shocks will be more persistent.

Second, even though there is not too much that the ECB can do about supply-side driven inflation, there is a general sense that a very accommodative monetary stance is no longer appropriate. The ECB therefore wants to normalise policy or take it back to more neutral levels. While there is a lot of uncertainty about where neutral is (for more on this see below), there is broad agreement in the Council that it is much higher than current levels and also above zero percent.

Third, the upward revision to our profile for the Fed’s target range means that there would be additional downward pressure on the euro if the ECB does not continue to raise interest rates over the next few months. A weaker currency is undesirable in this environment, as it would add to imported inflation. Indeed, in contrast to the last few years, we now live in a world of ‘reverse currency wars’. To be clear, the ECB will not be able to prevent the euro from falling, but it can reduce the extent of the decline.

The above factors have seen ECB officials step up their hawkish rhetoric over recent weeks. The more hawkish wing of the Council are pushing for 50bp steps, though we judge at this point that a majority are in favour of 25bp steps.

What is the case for the ECB to stop hiking at 0.75%?

The key factor is that we expect economic growth to slow considerably to clearly below trend rates from early next year. The economy has a number of cushions in the near term, such as a continued post-Covid recovery in the services sector, significant household excess savings and unsatisfied demand for everything from industrial orders to employees. However, these cushions will likely deflate next year, just as the impact of monetary tightening in the eurozone and globally feeds through. At the same time, the policy rate by then would be closer to more normal levels.

Where is the neutral rate?

When a central bank claims an intention to normalise policy, a key question is of course is what is the ‘normal’ or ‘neutral’ rate. The honest answer to this question, which holds for any kind of variable based on an equilibrium concept, is that nobody really knows until you get there. There is a wide range of academic estimates for the neutral rate, which in nominal terms ranges from around 1-3%, while the average of these estimates is just below 2%. At the same time, a market estimate of the neutral rate that the ECB watches (the 2y9y forward), is also running at around 2%. This seems to be broadly in line with recent official commentary. However, we have doubts about whether the neutral rate is that high. Looking at the period of negative interest rates (combined with extraordinary asset purchases), provides little evidence that the domestic economy was running very hot during this period. Yet this is exactly what one would expect if actual policy rates were so significantly below neutral. More on this topic will follow in a forthcoming publication. (Nick Kounis & Aline Schuiling)