By Elliot Clarke, Senior Economist at Westpac
FOMC see peak fed funds of 5.1% and slow return of inflation to target. But they have a growing awareness of downside activity risks.
As expected, the FOMC delivered a 50bp increase in the fed funds rate at its December meeting, taking the mid-point to 4.375%. Also in line with our view, the Committee displayed a hawkish disposition, expecting the fed funds rate to end-2023 and 2024 at 5.1% and 4.1% (4.6% and 3.9% in September), only coming back to 2.5% in the ‘longer run’. This policy view is predicated on inflation only returning to target in 2025 (2.1%yr for headline), with PCE inflation seen at 3.1%yr and 2.5%yr at end-2023 and 2024 (previously 2.8%yr and 2.3%yr).
The FOMC’s updated view on the fed funds rate is only marginally higher at peak than our own (Westpac 4.875% at March 2023), but the deviation is much wider at end-2024 and 2025, with our forecast for fed funds at the end of each of these years respectively 2.875% and 2.125% versus 4.1% and 3.1% for the FOMC. That key target for the federal funds rate by end 2024 of 2.875% is much more in line with market pricing of around 3% than the FOMC’s forecast of 4.1%.
For our forecasts to prove prescient, inflation obviously must fall faster than the FOMC currently expect, which requires a weaker economy. While we are in line with the FOMC for 2022 GDP growth (0.5%yr from the FOMC and 0.7%yr for Westpac), our expectation for 2023 is materially lower (-0.2%yr compared to the FOMC’s 0.5%yr). In our view, only if the FOMC cut aggressively through 2024 can growth rebound back above potential and begin to recover some of the output gap created by tight policy through 2022 and 2023.
In Chair Powell’s press conference, inflation risks and the need for policy to respond was a primary focus. Currently, as per the Committee’s forecasts and the upward revision to the fed funds peak, members believe that the risks remain skewed to the upside. However, Chair Powell was clear that the FOMC’s views and policy decisions will evolve with the data.
Interestingly, when asked about financial conditions during the press conference, Chair Powell focused on the fed funds rate not term interest rates – the latter having been the focus for the past year. Arguably this speaks to peak fed funds being near, and the market pricing not only expectations of it but also the subsequent actions of the FOMC. For the market, all else equal, a higher peak could simply mean an earlier or larger cutting cycle, and hence stable or lower term interest rates.
As long as annual inflation continues to decelerate rapidly towards target, and wages growth slows, the FOMC will arguably be happy to let the 10-year yield move modestly lower through 2023 as this will result in real term interest rates remaining materially-above zero. With a 10-year yield forecast of 3.10% for December 2023, this is essentially our baseline view.
Fed fund rate cuts however cannot come until the Committee believe inflation will sustainably return to the 2.0%yr target, and this is unlikely before 2024. Although, if we are right in expecting inflation to print near 2.0%yr through 2024 and beyond, the FOMC can cut aggressively in 2024 and 2025 back to a broadly neutral level. By June 2025, we see the fed funds rate at 2.125%, 275bps lower than our peak forecast and 300bps below that of the FOMC. Clearly, if inflation risks sustain, cuts could come later and/or at a slower place.
