Data as of February 28 2022. Sources: WTIA, Bureau of Labor Statistics, Macrobond.
Interest rates: The median of the Fed’s quarterly economic projections for the federal fund rate target pointed to more rate hikes with a total of seven for this year (as compared to three hikes projected back in December), three and a half hikes next year (each of 25bps, or 0.25%), and steady rates in 2024. As for the pace of hikes, Chair Powell emphasized the need to get rates back up to neutral2 levels as “quickly as we practicably can.” He highlighted that every meeting was “live,” and pointed out that projections pointed to seven hikes, while there are a total of seven meetings this year—all of which imply a base case of a 25bps rate hike at each meeting. But he did not commit to a pace, leaving options open for a potential 50bps rate hikes if needed.
Interestingly, the median terminal rate projection came in at 2.8%, slightly above the Fed’s long- run neutral projection of 2.4%. This in line with its acknowledgment that the easing of supply side pressures noted above is not likely to materialize in the near term due to the Ukraine war—putting the onus on the Fed to step in to suppress demand modestly rather than just remove accommodation. Powell’s comments also suggest that the demand side of the economy is too strong in the Fed’s view, as manifested by labor market tightness he described as being at an “unhealthy level.”
Balance sheet normalization: Not only does the Fed want to take away the punchbowl, it needs to get rid of the backup punch before partygoers find it. That is in the form of its large balance sheet that could fuel future inflation. The meeting statement indicated the Fed expected to reduce its holdings of Treasuries and mortgage-backed securities on the balance sheet “at a coming meeting,” with Chair Powell indicating that this could be as soon as May. He emphasized that the framework would be familiar to that of the last cycle, pointing to caps on reinvestment of maturing securities rather than sales of securities at this stage of the process.
Revising our view: Upside risks to inflation, downside risks for growth
Due to the extended nature of the Russia-Ukraine war and the impact of more stringent sanctions and voluntary actions from corporations restricting the supply of energy and other commodities, we recently updated our estimated economic impacts on U.S. growth and inflation. While our base case forecast for 2022 GDP growth remains at an above-trend 3.0% GDP growth rate, a sustained oil price increase to $125/barrel for oil (West Texas Intermediate) on average for the year would lower our forecast to 1.8% (since higher energy prices eat into consumer spending). Despite these risks, we still see the economy avoiding recession, as we expect solid household and corporate balance sheets to support consumer spending, business capital expenditures, and inventory rebuilding.
With regard to our inflation outlook, higher energy prices in the near term combined with surges in other commodity prices, sustained wage pressure, and normalizing housing costs (a big part of the inflation index) have pushed out the time of expected deceleration. We still look for the deceleration to occur, but the magnitude of recent commodity price movements and the delay in slowdown brings the 2022 year-end CPI forecast to 4.5% y/y—up from our base case forecast at the start of this year of 3.0% y/y (Figure 3). If the month-over-month gains in inflation moderate in the second half of the year as we expect, the Fed will likely have room to normalize policy at a slower pace.
Figure 3: Russia-Ukraine war pushes our inflation forecast higher