It’s not what the Federal Reserve is doing, but what it says it might do in the future that will be most crucial when the central bank wraps up its two-day meeting on Wednesday.
The Fed is expected to launch another three-quarter point rate hike – its third in a row. It will also release quarterly forecasts for inflation, the economy and the future path of interest rates on Wednesday at 2 p.m. ET.
Fed projections are always important, but this time they are even more important because investors have tried to outsmart how high, it will raise interest rates and how officials expect their actions to affect the economy.
Fed Chairman Jerome Powell speaks at 2:30 p.m. ET, and he is expected to stress that the central bank will do what it takes to fight inflation and is unlikely to reverse its rate hikes any time soon.
“I think he’s putting up a bulletin board behind him that says ‘Inflation has got to come down,'” said Rick Rieder, BlackRock’s chief investment officer for global fixed income. “I think he’s going to talk tough.”
The new forecasts also come as the central bank enters a zone of higher rates which some economists believe will be more restrictive and could have a more serious impact on the economy.
“It’s not what they do, it’s what they say. This is our first real tightening roadmap. We had notional roadmaps so far, but from the Fed’s perspective, they are entering a world of tightening. This is an important thing,” said Diane Swonk, chief economist at KPMG.
The Fed has been raising rates for seven months now and will now move its target rate above what was considered the neutral zone when inflation was low. Neutral is considered the interest rate level where Fed policy is no longer easy but not yet restrictive. The Fed considered 2.5% to be neutral, and if it rises three-quarters of a point, the fed funds rate will be in the range of 3% to 3.25%.
“This is really getting into restrictive monetary policy territory. We’re going to be moving into no man’s land,” Swonk said. Their goal is a prolonged slowdown that slowly reduces inflation and only gradually increases the unemployment rate.Whether they get there is another matter.
Rate expectations jumped
Economists have raised their forecasts for how high they expect the Fed to hit the fed funds target before halting hikes. This level is called the terminal rate.
Expectations of Fed tightening rose significantly last week, after a surprisingly hot consumer price index report in August. On Monday, federal funds futures were pricing a terminal rate of 4.5% in April, up from just around 4% before the inflation report was released last Tuesday.
The CPI rose 0.1% in August, when economists expected a decline.
“The IPC number last week did a lot market repricing conditions”, said Peter Boockvar, chief investment officer at Bleakley Advisory Group. Stocks sold off and bond yields rose after that report, with some short-term Treasury yields exceeding 4%. The 10-year Treasury yield rdare to 3.59% on Tuesday, the highest since April 2011.
The Fed’s latest forecast, in June, put the federal funds terminal rate at 3.8% in 2023.
Economists now expect the Fed to raise the expected terminal rate above 4%. Citigroup economists said they could even see a scenario where it could top 5% if the Fed were to become more aggressive in its fight against inflation.
Goldman Sachs economists, in a report, said they expect the median forecast from Fed officials to point to a funds rate of 4% to 4.25% by year-end, with a further rise to a high of 4.25% to 4.5% in 2023. They then expect a reduction in 2024 and two more in 2025.
Labor market pain
Swonk expects some of that pain to translate into a jump in the unemployment rate above 5% by the end of next year.
In June, the Fed forecast that the unemployment rate would be 3.7% this year, the same level as in August. Fed officials also expected unemployment to hit 3.9% in 2023 and 4.1% by 2024.
“I think they’re going to be a little light on the unemployment rate. I’m in the camp that they really need to raise the unemployment rate to really push inflation forward,” said Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management. “They’re in the camp of ‘We don’t have to do this.'”
Caron said the Fed’s rate hike is a process that will increase the risk of a recession.
“By increasing the risk of recession, you reduce the risk of inflation because it’s all about reducing demand in the economy,” he said. “The sacrifice is slower growth in the future.”
Some investors are betting the Fed will raise rates by one percentage point, but most economists are looking at a 75 basis point hike. One basis point is equal to 0.01 percentage point.
“I think 75 basis points is pretty much built into the cake,” Caron said. “Now it’s going to be about what they actually tell us…. They don’t want to do forward orientation, but the reality is people are still going to look at them for forward orientation.
‘Out-hawk’ the market
Powell took on a more hawkish tone. He gave a short and direct speech at the annual Fed symposium in Jackson Hole at the end of August, where he warned that the economy could suffer from Fed tightening. The president stressed that the Fed will use economic data to guide policy, and he also stressed that policymakers will keep rates high until inflation subsides.
“I think the message will be largely the same as Jackson Hole,” said Michael Gapen, chief US economist at Bank of America. “It’s going to be about making the policy restrictive, doing it there for a while, the overarching goal being price stability.”
Caron said it’s possible Powell could inadvertently appear dovish because the Fed bowed very hawkishly.
“I think a 75 basis point move is pretty darn hawkish, the third in a row,” Caron said. “I don’t think they have to work very hard to ‘overtake’ the market.”