US Federal Reserve tries to assert itself

Please note: The article does not constitute advice or any form of investment recommendation.

As storm clouds continue to gather over the US economy, there is greater pressure on the world’s most influential central bank – the US Federal Reserve (Fed) – to assert its authority.

Having swiftly shaken off the initial “transitory” label, post-lockdown inflation has left an ugly footprint across global economies this year. In response, the Fed has been accused in some quarters of being late-to-the-party in addressing it. And so it fell to Fed chair Jay Powell, to announce the decision to hike US rates once again by 0.75%. It was the third 75bp hike in a row, bringing the fed funds target range to 3.00%-3.25%.

In many ways, the hike isn’t ‘new news’. Markets – which are typically forward-facing - had already priced it in because the reality of rising prices, consumer behaviour and a tight labour market, left policymakers with little alternative but to hike. Observers were arguably more interested in two areas:

1. How fervent the central bank felt it needed to be
2. What specific messaging it used to explain its decision

Getting a firmer grip

Reflecting the scale of current macroeconomic challenges, the Fed yesterday struck a more-hawkish-than-anticipated tone, underpinned by its new projections.

In trying to make up for lost ground this year, the new ‘dot plot’ – (ie: the short-term projection of interest rates) - now suggests a median rate at 4.4% by the end of 2022, and 4.6% in 2023.

In contrast to previous messaging, when the US central bank emphasised that policy must adjust with the “totality” of the data, it seems it has high confidence in its new plan. In the words of Mr Powell: "The path that we actually execute will be enough. It will be enough to restore price stability¹".

Growth sacrificed?

Yesterday’s announcement signalled that the Fed has dropped its dual mandate – (maximum employment and price stability) – to focus fully on inflation.

With regards to the 2% inflation target, chair Powell commented that, “the chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive, or restrictive for longer. Nonetheless, we’re committed to getting inflation back down to 2%¹”.

The central bank appears willing to sacrifice growth and is determined to cool the job market. While the unemployment rate has shown some signs of easing lately, policymakers seem concerned about the elevated rate of job quits and the high level of job openings, which continue to put pressure on wage growth.

It remains uncertain at what stage the US economy may find its longer-term equilibrium. While we don’t believe it will be a triple 5% with regards to unemployment, policy rates, and inflation (on the way to the Fed’s target), it may not be very far off from this. By now, and especially after the U-turn in 2019, it is also evident that the path of the US economy and the market may play out differently and may need to be adjusted.

Waiting game

A moderation of inflation seems still very likely given various factors like base effects, a rapidly cooling housing market, and disinflationary trends in components like airfares, autos, health insurance, and some materials.

As such, a CPI below 3% by the end of 2023 seems plausible. While a fed rate of 4.5-4.75% at the peak by the first quarter of 2023 now appears more likely, so are interest rate cuts at the end of next year.

Only time will tell whether yesterday’s more aggressive tone and shift in mandate (at the expense of growth), will be enough for the Fed to restore confidence. After recent months of reactive decision-making and foggy communication, chair Powell will be hoping he’s done enough.

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