It’s a given that the Fed will hike rates faster than the RBA but by how much? Pantheon with the note:
We have had two rate hikes in our 2022 forecast for more than a year, but we’re now adding a third.
Our base case now is that the Fed will hike in May, September and December, with a further three hikes in 2023. To be clear, we are not abandoning our view that inflation will be much lower a year from now, and back to the target in early 2023. But our inflation forecasts for the next few months are grim, with core CPI inflation likely to come alarmingly—through briefly—close to 7%, thanks to the latest surge in vehicle prices, rebounding airline fares, and hefty increases in rents.
These numbers will pile pressure onto the Fed to take early action beyond the acceleration of the tapering, which will be announced at next week’s FOMC meeting and will see asset purchases end in March. We expect Chair Powell to characterize the first rate hike as extra insurance against the risk that inflation remains higher for longer. Mr. Powell has already “retired” the term “transitory” and now argues that the risk to inflation is mostly to the upside. For the next few months we have no argument with that idea, but the medium-term picture is more nuanced.
In order for inflation to return to the target by early 2023, three things have to happen. First, the pressure on global supply chains has to ease considerably, and chip supply has rise to the point where auto production can meet demand, bringing prices back down from their current stratospheric heights. We’re confident this will happen, not least because business surveys show that supply chain pressures peaked back in the late spring and are now easing, albeit quite slowly.
At the same time, shipping costs are falling, and exports of chips from Korea and Taiwan are rebounding.
The odds that these favorable trends continue over the next year are high, perhaps 90%. Global supply chains are very large and complex systems, and their response to a sudden upside demand shock—mostly driven by surging U.S. consumers’ spending on goods—was never going to happen overnight. It is, however, inevitable that the response will come.
Second, productivity growth has to rise, in order to constrain the rate of growth of unit labor costs, the key medium-term driver of inflation. We think that’s maybe an 80% probability. Orders for capital equipment, which are the nearest thing we have to a real-time measure of productivity growth in the near future, have soared since the summer of 2020, and now stand more than 20% above their flat pre-Covid trend. With businesses awash with cash—or near-free and easy credit—and a huge backlog of deferred replacement capex from the previou cycle still needing to be done, we expect spending to keep rising strongly.
Third, wage inflation has to slow sharply from the 6.5% annualized Q3 pace. We see some evidence that this is already beginning to happen, as we noted in the Monitor yesterday, but the picture is not yet definitive and no prudent policymaker could assume it will continue, given the current unprecedented gap between labor supply and demand, shown in our next chart. In order to be confident that wage inflation is going to slow to a non-inflationary pace, labor participation has to break meaningfully to the upside, after recovering only half the drop since Covid began. The trend has been flat since the summer of 2020. We still think a sustained increase is a decent bet, but it’s far from certain and it hasn’t happened yet. We’d put the odds at about 70%.
If our subjective probabilities are right, then the odds of all three of these developments coming to the rescue of the medium-term inflation story is just 50%. Those odds aren’t terrible, but they’re a long way from the degree of confidence a central bank would like to have, in the face of a near-term core inflation rate which soon will likely be three times the target. Further insurance, beyond the acceleration of the taper, therefore likely will be needed. Markets already put the chance of a rate hike by May at 66%, so the Fed would be pushing on a nearly-open door.
After a May hike, we expect the Fed to sit out the summer awaiting clear evidence that both the immediate inflation spike is over and that the medium-term story is evolving favorably. Even in the best-case scenario, though, rates will have to rise further, because sustained strength in productivity growth will raise
the neutral real interest rate, r-star. No one has given much thought to r-star during the pandemic, understandably, but it will come back into the Fed’s thinking once more normal macro conditions emerge.
Before Covid, the New York Fed’s r-star estimate was rising, as our final chart shows, but they ceased publishing the numbers after the initial Covid shock.
Our productivity forecasts, coupled with the transformation of private sector balance sheets by rising asset prices and huge cash injections from the federal government, strongly suggest that the neutral rate will rise. If we’re right, the Fed’s forecasts for the neutral nominal rate, currently 2½%, and the terminal
rate for this cycle will have to go up too; the highest FOMC member’s forecast for 2024 was just 2.4% in the September projections. This scenario, however, would be much less bad for markets than the alternative, in which the Fed has to chase out-of-control inflation, seeking actively to slow the pace of economic growth. The stakes could hardly be higher.