Fed Policy May Trigger a More Severe Recession

Fed Policy May Trigger a More Severe Recession than Previously Forecasted 

Insights for What’s Ahead

• The Fed hiked interest rates by 75 basis points today and indicated that more large interest rate hikes are on the horizon. This could trigger a more severe and potentially longer recession than we have forecasted.
• Both the policy statement and Chair Powell were much more hawkish in tone and acknowledged that the likelihood of achieving a “soft landing” for the economy is diminished.
• Businesses should expect interest rates to rise much faster and higher than previously anticipated. The Fed funds rate may levitate to 4.4 percent by year-end 2022 and to about 4.6 percent by the end of 2023.

What were the Fed’s actions?

The Fed made another large 75 basis point rate hike in September and pushed the Fed Funds window to 3.00 – 3.25 percent. This increase elevates rates above the ‘neutral’ range of two to three percent and into ‘restrictive’ territory. FOMC participants also materially raised inflation projections and significantly increased the number of interest rate hikes it expects in 2022 and 2023. While Chair Powell said that monetary policy decisions will continue to be made on a meeting-by-meeting basis, he acknowledged that the likelihood of achieving a “soft landing” for the economy is diminished. In terms of the Fed’s balance sheet reduction plans, no changes were made.

What does this mean for the US economy?

The Federal Reserve’s Summary of Economic Projections (SEP) anticipates significantly slower real GDP growth over the forecast horizon (Figure 1). The FOMC projects 4q/4q 2022 GDP growth of 0.2 percent and 4q/4q 2023 GDP growth of 1.2 percent. These are large downgrades from the growth expectations that were released in June. The FOMC also raised its expectations for inflation. The FOMC projects 4q/4q 2022 PCE inflation of 5.4 percent now compared to 5.2 percent at the June meeting. For 4q/4q 2023, it forecasts 2.8 percent.

These growth expectations are too optimistic, in our view. Our base case assumption was that the Fed Funds rate would rise to a mid-point of 3.6 percent at the end of 2022 and 3.9 percent in 2023, vs. the September SEP’s 4.4 percent and 4.6 percent. If the SEP’s Fed Funds projections are accurate, then there will be even greater headwinds to US economic growth than our base case projections. According to a recent set of scenarios conducted by The Conference Board (see StraightTalk® – Wide Bands of Uncertainty) a terminal Fed Funds rate of 5 percent could shave as much as half a percentage point off of our 2023 Real GDP growth forecast of 0.3 percent year-on-year. Given the Fed’s guidance today, we will likely be downgrading our 2023 forecast soon.