Fed Sets Up a Pause, Not a Pivot
Upside inflation surprises prompted the U.S. Federal Reserve to hike its policy rate by 75 basis points (bps) for a historic fourth time. This brought the fed funds rate up to a 3.75%–4% range, meaningfully above the Fed’s 2.5% median long-run estimate, as elevated inflation continues to justify contractionary monetary policy.
Despite continued upside inflation surprises, the Fed also altered the forward guidance in its November statement to emphasize the amount of tightening to date and the lags with which monetary policy impacts the economy. While the statement language left the door open to a further continuation of 75-bp rate hikes, we interpret the language changes as setting up the Fed for a pause in the hiking cycle in early 2023. At the press conference, Fed Chair Jerome Powell emphasized that the Fed may slow the pace of rate hikes as soon as the December meeting, while also warning that the ultimate destination for the fed funds rate may also be higher than previously anticipated as inflation is now higher and appears stickier than the Fed’s forecasts at the September FOMC meeting.
Overall, the statement and Chair Powell’s comments were consistent with our view that the Fed is aiming to pause interest rate hikes in early 2023 as it assesses the impact of tightening to date. Long lags between monetary policy action and effect, plus heightened recession risk and uncertainty around the inflation outlook, all appear to justify a more measured pace of tightening in the months ahead, following what has been an even more rapid tightening in financial conditions than we saw in 2008.
If the bond market’s response to the statement and press conference offers any indication, the Fed is managing a challenging communication balancing act between trying to shift the pace of tightening while keeping financial conditions sufficiently tight amid elevated inflation. Markets initially sent U.S. Treasury yields lower across the curve given the dovish statement changes, before reversing course as Chair Powell emphasized that markets should expect further rate hikes and the possibility of a higher terminal rate.
We now expect the Fed to raise the policy rate by 50 bps in December and then pause early next year in the 4.5% to 5% range. We are separately forecasting the U.S. economy to slip into recession in early 2023 (see our Cyclical Outlook for a full discussion of the economic landscape), at which point we think the Fed will find it prudent to pause. Yet we don’t think the Fed will be quick to cut with inflation still elevated.
Preparing to pause
Chair Powell’s relatively hawkish press conference comments contrasted the dovish statement. Even though Powell was clear that it is not yet time for the Fed to stop hiking interest rates, we view the statement changes and his comment that it was possible the pace could slow as soon as the next meeting as a first step in this direction.
There are three main reasons why we believe it makes sense for the Fed – as well as other major central banks – to pause interest rate hikes once the policy rate has reached a meaningfully restrictive level:
- First, and most important, monetary policy works through lags. This means that with perfect foresight central banks shouldn’t shift policy based on what inflation is doing today, but rather what they forecast inflation to do one to two years from now. However, a forecast-dependent strategy becomes difficult when inflation model credibility comes into question, as it arguably has today. Nevertheless, central banks’ forceful policy approach to the inflation surprises to date should restore some credibility in their willingness and ability to meet price stability mandates. In other words, front-loading hikes may have bought officials some time to pause.
- Second, recession risk is elevated. We think a U.S. recession is more likely than not, and the speed and global synchronized nature of this tightening cycle risks reinforcing and amplifying the impact of tighter financial conditions. In the U.S., there are still good reasons to believe that the size of the coming economic contraction will be more moderate than what was realized in 2008. However, the sheer speed and magnitude of the financial tightening against a backdrop of already weak real GDP growth risks overdoing it, if the Fed were to maintain 75-bp hikes.
- Third, central bankers must also manage the risk that inflation eventually falls just as rapidly as it has risen. Even though we see signs that inflation is likely to be sticky on the way down, and therefore slower to fall back toward central bank targets, this outlook remains uncertain. A key uncertainty is the so-called Phillips curve, or the sensitivity of inflation to the output gap (the difference between actual and potential output of an economy). Economists agree that between the 1970s and 1990s the Phillips curve became markedly flatter, which is fine when inflation expectations are anchored, because realized inflation does not move much in the face of large changes in the output gap. However, when inflation expectations are moving higher, a flat Phillips curve means a large contraction in economic activity is necessary to restore price stability. Recently, there has been growing discussion that the pandemic may have shocked the Phillips curve. Formal estimates by Gita Gopinath, first deputy managing director of the International Monetary Fund, suggest that Phillips curves across industrial economies are steeper post-pandemic. While this doesn’t seem certain now that wage inflation is accelerating, the glass-half-full implication is that central banks will also need to do less to bring it back down.
With U.S. inflation poised to remain well above the Fed’s target in coming months, the Fed faces a difficult communication balancing act. The challenge is not only how to communicate the pause while inflation is still elevated, but to communicate it in a way that convinces markets that the Fed is still focused on bringing down inflation, and that it isn’t going to quickly pivot to dropping rates in the face of what is likely to be increasingly weak economic activity. Although the Fed may not want to tighten financial conditions meaningfully further, they also won’t want to ease financial conditions prematurely. As a result, Fed officials will likely have to convince markets that they are expecting to hike further, even as they are slowing the pace of hikes or even pausing.
At the November meeting the Fed walked this tightrope by acknowledging the cumulative impacts of tightening in the statement, while having Chair Powell warn market participants not to expect the Fed to stray from its full focus on fighting inflation.
Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.
Tiffany Wilding and Allison Boxer are economists and regular contributors to the PIMCO Blog .
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