Fed says smaller hikes, but no pause on the horizon

Insights for What’s Ahead

• The Fed hiked interest rates by 75 basis points today. Chair Powell said more hikes are coming, but probably in smaller increments. No pause in hikes is on the immediate horizon and the terminal Fed Funds rate will likely be higher than the one seen at the Fed’s September forecast. We are therefore raising our Fed Funds forecast to hit a window of 4.75 – 5.00 percent (midpoint of 4.875 percent) in March 2023.   
   
• Chair Powell said that the FOMC is taking into account the cumulative tightening that occurred this cycle as well as the lags with which tightening affects the economy. Looking ahead, Powell said that the window for a soft landing is continuing to diminish because inflation is not coming down.
   
• Businesses should expect interest rates to continue to rise, but at a slower pace. However, as the impact of the rate hikes seen in 2022 continue to weigh on the economy, The Conference Board forecasts that a recession is likely to begin around the end of the year and run three quarters.

What were the Fed’s actions?

The Fed hiked by another 75 basis points in November and pushed the Fed Funds window to 3.75 – 4.00 percent. This increase raises the rate further into ‘restrictive’ territory (anything above 3 percent). The Fed also said that there will be no change to its ongoing plan to reduce the size of its balance sheet (currently $95 bln per month), which was first unveiled in May 2022. Today’s actions were unanimously approved by the members of the Federal Open Market Committee.

What does this mean for the US economy?

The Federal Reserve’s actions today were widely anticipated, but its tone about the future shifted somewhat. In the policy statement, the FOMC said it will “take into account the cumulative tightening in monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” This new language suggests that this may be the last 75 basis point rate increase seen this tightening cycle. Indeed, Chair Powell said that a downward shift to a 50 basis point hike will be discussed at the December FOMC meeting. However, Powell also said that the terminal rate this tightening cycle is likely to be higher than the one the Fed forecast in September (4.50 – 4.75, with a midpoint of 4.625 percent). As a function of this, The Conference Board now expects rates to rise to 4.75 – 5.00, with a midpoint of 4.875, in March 2023. We do not expect to see the Fed lower rates next year.

Since tightening started in March 2022, the Fed Funds rate has risen by a total of 375 basis point. As a function of this, interest rates throughout the economy have risen rapidly. Tighter policy has begun to cool the overall economy – though with a lag. While the labor market remains exceptionally tight, other parts of the economy have begun to slow (like consumption and business fixed investment) while other parts have begun to contract (like residential investment). As the full impact of this year’s Fed Funds hikes continue to weigh on businesses and consumers, economic activity will slow further – tipping the economy into a broad, but shallow, contraction. This recession should begin around the end of 2022 and is expected to last for three quarters.