Higher for longer

The Fed hiked by 75 bps as expected and struck a hawkish tone. In truth, Jackson Hole stole the limelight from this meeting, with Fed chair Jay Powell very much reiterating the tone of his speech then. The Fed is committed to bringing inflation down at any cost, especially given price pressures overshot consensus expectations – both on a headline and core basis – last week.

However, it was the dot plot – that indicates the central bank’s rate projections – that shows the Fed’s thinking that interest rates need to be higher for longer to tame inflation. Rates are expected to reach the mid 4% level by the end of the year (in line with markets) – though markets pushed out the peak in the Fed funds rate from March to May.¹ The central bank projects rates to stay at a similar level throughout 2023 to end the year at 4.6% (up from 3.8% in June). Rates are then expected to decline towards a (surprisingly) unchanged long-term dot of ~ 2.5% (indicative of the long-run neutral rate of interest).

The Fed’s forecasts for both growth and unemployment were also revised down:

• 2022 real GDP growth was downgraded from 1.7% to 0.2%, while 1.2% is expected for 2023 (0.5% lower).
• Unemployment forecasted for next year was also revised up from 3.9% to 4.4% (currently 3.7%).

The Fed’s projections for unemployment and growth seem optimistic, in our view, given the degree of monetary tightening, but only time will reveal to what degree this is wishful thinking.

Recession risk mounts

Powell’s desire for a period of “below-trend growth” to tame inflation is more likely to materialise in recession. While we acknowledge that the strong labour market can cool off as hiring plans are scrapped, history shows that the rise in the unemployment rate projected by the Fed is consistent with recession.

With central bankers in a “shoot first, ask questions later” mood, this may set up the global economy for a fall, especially as monetary policy works with a lag. While we can see the more rate-sensitive parts of the economy experiencing weakness (i.e., housing), this is seemingly ignored by central bankers and now to some extent by markets, given the former are tending to focus on current inflation.

Other central banks like Sweden’s Riksbank (by a hawkish 100 bps) this week have hiked rates and forecasted two consecutive quarters of -0.5% growth this year (following the Bank of England’s lead on forecasting a recession). The Swiss National Bank hiked by 75 bps, bringing its interest rate into positive territory. Central banks know that to bring inflation down through monetary policy, they need to weaken demand (reflected in growth and unemployment) but the issue is, when it occurs, how do you achieve this without causing significant economic stress. Even in the US, the chances of a soft landing are slim.

Yield curve inverts to lowest level seen since 2000

What was notable about the bond market reaction is two-year yields continued to make new highs for this cycle, while the yield curve was sharply flatter, as the Fed re-emphasised its commitment to seeing inflation lower. With elevated recession risks and central banks in a whatever-it-takes mode to lower inflation, we expect government bond yields to recouple to the weak economic outlook over the longer run; however, in our view, the peak in bond yields is unlikely to be seen just yet, given a more decisive turn in inflation is needed first.