The Fed hasn’t announced such a big interest rate hike since 1994. So why did they feel compelled to raise rates by 75 basis points at the June Federal Open Market Committee (FOMC) meeting? What might it mean for its plans to tame inflation? How fine a balance do they have to strike to avoid an economic recession? Here are some thoughts and observations.
Why the 75bper?
A 50 basis point hike appeared to be a lock until a late Monday (June 13) afternoon article from the foremost Wall Street Journal Fed journalist Nick Timiraos basically confirmed a 75bper was incoming. Little by little similar articles hit the wires. Despite the Fed’s blackout period, articles like that don’t happen by accident – 75 bps incoming.
As we know now, the Fed chose to blow up its forward guidance and go 75 bps on June 15 to emphatically demonstrate its commitment to fighting inflation.
- As expected, the updated Dot Plot shifted materially higher:
- FOMC members tacked on another 150 basis points of hikes in 2022 to close the year at 3.5%.
- The terminal rate in 2023 ticked up 100 bps from the March projections, to 3.75%.
- 2024 was revised up to 3.5%, indicating a cut while the neutral rate remained essentially unchanged at 2.5%.
In short, it is hawkish on the surface but less so when compared to lofty market expectations, which placed the terminal rate around 4% with concerns it was even higher. And to top things off, there was one dissenter – the well-known hawk Esther George who likely preferred more 50s to a 75.
What Did the Fed’s SEP Reveal?
Aside from the Dot Plot, the SEP (Summary of Economic Projections) was somewhat alarming at first blush.
- GDP forecasts were revised meaningfully lower and the unemployment rate was projected to rise each year in the forecast horizon, while headline and core PCE (Personal Consumption Expenditure) were both marked up.
- With growth rates dropping to 1 handles in each year and the unemployment rate moving up from the current 3.6% to 3.7% by year-end and 4.1% by 2024, the forecasts appeared to paint more of a “softish” landing with higher risks of recession.
- But before we all scream recession is coming, let’s remember these are forecasts, and like all other forecasts they are subject to change. And most importantly, forecasts will not be used to set Fed policy. Actual data will determine the path of policy.
What Did Powell Say?
Fed Chair Powell’s press conference seemed to contrast what was seen in the SEP:
- He tried his best to uphold the hawkish tone but continued to stress flexibility, nimbleness, and data dependence – they want to move quickly now but are prepared to adjust rapidly as the data warrants.
- Powell also demonstrated they are well aware that normalization is likely to resolve many inflationary pressures, potentially rapidly, but they are no longer willing to wait and depend on those constraints normalizing quickly as food and energy prices rise.
- The Fed is looking for clear and convincing evidence of inflation moving back towards their 2% target – that means sequentially softening monthly prints.
- Why 75bps instead of 50? An upside surprise with the May CPI (Consumer Price Index), but most critically, the firmer inflation expectations reading from the University of Michigan survey.
Taming Inflation Top Focus
Enemy #1 is now inflation expectations, which means the Fed will be keenly focused on headline inflation and food and energy prices.
- Core inflation is the best predictor of future inflation, but the Fed views expectations unanchoring as the greatest risk to inflation returning to its 2% target.
- Consumers don’t experience core, they experience headline – and goods and energy prices specifically are the biggest drivers behind shaping expectations.
- Recent Fed research has shown the dubious link between expectations and actual realized inflation, but nonetheless keeping expectations anchored is critical in the Fed’s eyes.
- Policy can’t improve food and energy supply, but it can constrain demand – the Fed’s goal is to keep those expectations in check.
We still think there is a good chance that we could see inflation pressures moderating through this year – and when looking at core PCE we are already seeing clear and convincing evidence of improvement. But the Fed is playing the expectations card until the data improves further. At the end of the day, the Fed will remain data-dependent – and should that data improve faster than current forecasts, then less tightening will be warranted.
Any Signs of Normalization?
Wednesday morning alone brought more evidence of normalization:
- Soft retail sales and downside revisions (as consumption rotates toward services and cools at lower incomes).
- Import prices falling for the first time since 2020.
- Empire Fed showing a meaningful drop in delivery times and backlogs.
Put that together with the other green shoots we already know – labor market slack easing, wage growth slowing, inventory gluts being discounted… This may not have been Powell’s finest moment, but it may be enough to get us moving in the right direction.
Are Inflation Expectations Too High?
Here is one chart to address the phrase of the day: inflation expectations. No one is perfect at forecasting, but one thing is clear: 500 random consumers consistently overestimate actual inflation.
The chart below compares consumer and professional forecaster expectations with the actual subsequent inflation rate. Yes, longer-run expectations have drifted higher, but they are not unanchored. And more importantly – they’re usually wrong. Professional forecasters have historically been more accurate, but have fallen victim to the same overestimation trap as consumers. Expectations begetting reality is a long held notion, but the data and the Fed’s own research suggest otherwise.
Inflation: Actual vs. Expectations
This may have been a messy Fed meeting all around, but it may ultimately hit the mark. No doubt we’ll hear that the Fed is on autopilot and hiking into a slowdown and into recession:
- That they can’t address food and energy prices
- That they’re fighting the last battle by looking in the rearview mirror
- That even one of the most hawkish members even dissented
- More fuel for the growth scare once the inflation scare begins to fade
To be clear, there are risks – will they overreact to expectations and a commodity surge they can’t address and could potentially exacerbate? But remember, they’re not on autopilot. They’re data-dependent. And despite the narratives floating around since Friday, June 10, the data is getting better.
Keep those seat belts fastened. It’s going to be a bumpy ride.
A basis point is one hundredth of one percent.
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