Nuance at the Federal Reserve

The Federal Open Market Committee (FOMC) is scheduled to meet on December 13-14. The Federal Reserve is widely expected to raise rates by 0.5% although some at the meeting may push for another 0.75% hike. Fed Chairman Jay Powell made clear in his last speech prior to this meeting that the Fed was committed to moderating rate hikes as it approaches what he now expects to be a higher terminal rate.

There is a slight chance that St. Louis President James Bullard, who has advocated for a higher end point on rates, could dissent in favor of another 0.75% percent hike. This is the last time he can cast a vote until 2025. He is scheduled to retire in 2026.

The FOMC will release its summary of economic projections (SEP) at this meeting. Participants compile the forecasts ahead of the meeting. The individual forecasts are expected to show a higher fed funds rate in 2023 than the Fed forecast in September, the last time the SEP came out. Unemployment for 2023 is expected to be revised up.

We are expecting the Fed to move up the end point on the fed funds rate to 5.5%. Market participants are expecting the high end to be 5.25%. Either way, that is above the 4.75% high end of the range expected in September.

The Fed is still widely expected to show a forecast of higher rates for much of 2023 with no cuts until 2024. The dispersion in the trajectory of the timing and magnitude of cuts is expected to be even more diffuse than it was in September for 2024 and 2025. Uncertainty over when and how rapidly inflation will cool is high.

Powell will emphasize the Fed’s commitment to reducing inflation. Its own forecast suggests that a rise in unemployment is necessary to do that. The Fed considers a stalling out of growth and a rise in the unemployment rate a “soft-ish” landing. Those who lose their jobs will beg to differ. Our forecast for a full-fledged recession has inflation cooling faster than the Fed and then lower rates sooner than many on the Fed expect.

The key to the press conference following the meeting will be the nuance that Powell conveys. The Fed is considering a whole spectrum of financial conditions when assessing how restrictive credit is becoming. The recent Senior Loan Officer Survey revealed a recession-level tightening of credit standards and loan covenants. Deal volume has evaporated, which is taking a toll on private funding, along with the push by pension funds to liquidate long-term, less liquid bets and opt into Treasury bonds.

Debate within the Fed as it approaches the terminal rate, what it should be and for how long it should hold it there will intensify. The Fed became fully staffed this summer for the first time since 2013. With those shifts, the ranks of the board and regional Fed presidents are more diverse than the Fed has ever seen. That means more high-quality debate, which may confuse financial markets but improve the decisions the Fed ultimately makes. Financial markets do better with decisions that are black and white than shades of gray. 

Charlie Evans of the Chicago Fed and Esther George of the Kansas City Fed are retiring in early 2023. Charlie’s successor has been named. Austan Goolsbee, who will have a voting role at his first meeting in 2023, will replace him. The University of Chicago Booth Professor has argued that the Fed would look through the lags on shelter costs to lower rates sooner than the data might otherwise suggest. The Fed has made clear it is taking the high frequency data on shelter costs into account to avoid overshooting by much on rate hikes.

Goolsbee will be joined by newcomer Lorie Logan at the Dallas Fed. Goolsbee and another newcomer, Susan Collins of Boston, bring more of a fiscal policy perspective to the table, while Logan ran the trading desk at the New York Fed and brings her knowledge of financial markets. Philadelphia Fed president Patrick Harker will rotate into a voting position. The group is considered to be less hawkish than some of the 2022 voting members. That is less important than the breadth and depth of debate. No one, including members of the Fed, knows exactly when they will move or reverse course and cut rates.

Our own take is that the Fed will want to see core inflation fall below 3% before cutting rates aggressively. There is much debate about stopping ahead of that. The Fed will be too reluctant to raise its target as it nears it, as that could undermine its credibility on inflation and unwittingly cause inflation to remain elevated for longer. A change in the Fed’s 2% inflation target is more likely to occur after the Fed has lowered inflation to below 3% for an extended period of time - a year or more.

Another less noticed but important debate within the Fed is emerging. Labor market shortages are becoming more structural than cyclical in nature. That means that the noninflationary rate of unemployment may now be much higher than it was prior to the pandemic. Powell himself raised the issue in his most recent speech, even mentioning a shift in immigration policy as a possible safety value. He has no say over immigration policy, but more legal immigration would allow the Fed to focus more on fueling employment and wage gains than containing inflation alone. Food for thought.