Fed Dramatically Shifts Forecasts, but Will It Hike Rates Sufficiently to Lower Inflation?

Fed Dramatically Shifts Forecasts, but Will It Hike Rates Sufficiently to Lower Inflation?

*The realities of higher inflation have finally hit the Fed. At this week’s FOMC meeting, the Fed dramatically raised its forecasts of inflation, acknowledging that it will persist into 2022 and 2023, speeded up its tapering to now conclude mid-March 2022, and significantly increased its estimates of the appropriate Federal funds rate, with the median FOMC member now projecting three rate hikes in 2022 and several more in 2023, lifting its policy rate to 0.9% by year-end 2022, 1.6% in 2023, and 2.1% by year-end 2024.

*This is a welcomed step in the right direction, and we applaud the Fed’s transparency in explaining its dramatic shift, which is consistent with our long-standing view that the higher inflation is persistent and that labor markets have been moving rapidly toward the Fed’s maximum inclusive employment mandate, but are the FOMC’s estimates of the Fed funds rate sufficient? If the Fed’s projections in its Summary of Economic Projections (SEPs) prove correct, and inflation recedes to 2.3% in 2023 while sustained strong economic growth reduces the unemployment rate to 3.5%, 0.5 percentage points below the Fed’s longer-run estimate of the natural rate of unemployment, raising the Fed funds rate to 1.6% would imply a negative real policy rate of 0.7% by year-end 2023; and by year-end 2024, the FOMC estimates that it would be appropriate to maintain a zero real funds rate.

*History suggests that the FOMC’s estimates of the rate hikes will be insufficient to slow aggregate demand sufficiently to lower inflation. The economy and inflation have a lot of momentum and inflationary expectations are influencing wage and price setting behavior, creating an upward feedback loop. We anticipate that the Fed will eventually have to raise rates well above the “dots” in the December SEPs.

*The dramatic shift in the SEP projections of inflation is revealing: following a year of arguing that inflation would fall back toward the Fed’s longer-run average 2% target in 2022, the Fed now projects PCE inflation in 2022 of 2.6% and 2.7% on core excluding food and energy, 2.3% inflation in 2023, and 2.1% in 2024. That’s a large upward revision for 2022, but from current lofty levels is such a decline in inflation achievable? Only if all of the supply bottlenecks clear up quickly, prices of goods come down, and aggregate demand slows sufficiently to take the edge off price pressures. That doesn’t seem likely to happen.

*Reflecting the recent significant improvement in the labor markets, the Fed has lowered its unemployment rate projection to 3.5% in 2022-2024. That’s back to its pre-pandemic low, consistent with the Fed achieving its employment mandate. A critical question is that with robust demand for labor and supply shortages, and higher inflationary expectations influencing wages, will this decline in the unemployment rate to 3.5% be consistent with inflation receding along the path the FOMC projects? That seems unlikely if the Fed maintains its policy rate below inflation.

*In his press conference, Fed Chair Powell was very clear in explaining the Fed’s pivot. Labor markets have improved significantly, and stresses are likely to persist, in part as the labor force participation rate recovers only gradually and a sizable number of older workers have retired. We would add that The American Jobs and Infrastructure Act will significantly increase the demand for construction workers and add to labor market shortages and stresses and higher wages. Powell expressed concern that further increases in wages may exacerbate inflationary pressures. Powell also noted that the Fed discussed the Fed’s balance sheet, which has grown to $8.6 trillion. For now, the Fed will continue to reinvest maturing assets and maintain the maximum size of the balance sheet.

*So now the stage is set for a quicker pace of tapering of asset purchases and rate increases in 2022 and beyond. The big issue is how much the Fed will have to raise rates. We think higher than the Fed and markets anticipate. Data may push the issue: During the December 2021-March 2022 period as the Fed tapers its asset purchases, further significant gains are expected in labor markets and wages, and it’s virtually in the cards that core inflation will rise further, with core PCE inflation rising close to 5%. So, while the Fed took favorable steps in its December FOMC meeting and SEPs, it will find that it has fallen even further behind the curve even before it begins raising rates.

Table 1. December 2021 Summary of Economic Projections

Table 2. Evolution of the Fed’s Inflation Forecasts Over Time

Mickey Levy, mickey.levy@berenberg-us.com

Mahmoud Abu Ghzalah, mahmoud.abughzalah@berenberg-us.com

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