Written by: Brian Gilbert | Advisor Asset Management
The 25bps (basis point) hike in March shows the Fed is prioritizing the use of monetary policy tools to fight inflation. It also seemed to indicate their confidence in the U.S. banking system as being “sound and resilient.” The change in the language from “ongoing increases” to “some additional policy firming” suggest the Fed funds rate is approaching a top. This message is consistent with the updated March 2023 dot plot below.
Source: Federal Reserve Board
The dot plot included in the Summary of Economic Projections (SEP) left the median expectation for the terminal rate unchanged at 5.1%, which the committee expects to reach in 2023, while it also indicated some participants continue to expect a higher terminal rate despite the banking crisis as the dispersion of Fed funds rate estimates for 2023 is wider than in the December SEP. Notably, there were seven dots above the median, with one as high as 5.9%
The SEP 2023 GDP forecast was revised down by only 0.1%, with a 0.4% mark down for 2024.A downward revision to this year’s GDP forecast (0.4% vs. 0.5% in December) comes after a strong 2.6% print in Q4 2022 and an expectation for another strong print for the first quarter of 3.2% according to GDPNow from the Atlanta Fed. This indicates significant slowing in the latter part of this year.
Source: Federal Reserve Board
Unemployment rate expectations were reduced by 0.1% in 2023 (4.5 from 4.6), left unchanged for 2024 at 4.6% and revised up for 2025 (4.6% from 4.5%). That reflects the impact from strong January and February nonfarm payroll reports, which likely made committee members reevaluate the condition of the labor market.
The 2023 projections continue to suggest it will be difficult to avoid a recession. According to the Sahm Rule, a recession usually begins when the unemployment rate’s three-month average rises by 0.5% above its low from the past 12 months. The central tendency in the SEP table above reflects a range of 4.0%–4.7% in 2023 which is consistent with a recession.
Core PCE (Personal Consumption Expenditure) inflation expectations were also revised up and is now expected to be 3.6% in 2023 (vs. 3.5% in the December SEP), and 2.6% in 2024 (vs. 2.5% prior) and only reaching 2.1% in 2025. The median fed funds rate expectation was unchanged at 5.1% in 2023 and ticked higher in 2024 to 4.3% from 4.1%.
The St. Louis Fed Financial Stress Index is another barometer for the Fed and reflects levels of financial stress in the U.S. economy. While the spread between high yield and investment grade debt captures one major component, the Index comprises a host of yield spreads, interest rates and other indicators.
The average value of the index is intended to be zero, capturing the time when the financial markets are in a “normal” state, with values above zero indicative of heightened stress. The markets have been relatively calm this week after significant volatility earlier this month, but the key question confronting the Fed is what the combination of widening credit spreads and a re-steepening of the Treasury curve tells us about damage already done to the economy. The chart below puts the significance of the recent move in perspective.
When reviewing the yield curve, the yield on 2-year Treasury declined 130bps from March 8 to March 2 as the 10-year dropped 62bps. This bull steepening move in the 10s/2s curve shifted the inversion from -107bps to -39bps. The speed and size of the move are another sign we may be closer to a recession than we thought three weeks ago. Yield curve inversions are known to suggest a pending recession, but a more significant sign is when the curve steepens from the inversion as shown below.
Hike, Hold or Cut?
A spin on Murphy’s third law would suggest that, “Everything takes longer than you think it will,” and then happens faster than you thought possible. An example was inflation remained below 3% from December 2011 until April 2021 and wouldn’t be problem…until it was. CPI then ran from 2.6% in March 2021 to 9.1% in June 2022 with Fed rate hikes beginning a year ago to slow inflation. Inflation, in this cycle, peaked nine months ago and has dropped to 6%. We would also point out as recently as March 8 the market was expecting rate hikes to 5.70% in September of 2023. Now the market is effectively pricing the end of the rate hike cycle, and the first cut at the July meeting.
Interestingly, the current estimates for a 25bps rate hike are still about 50/50, but a recession now looks unavoidable and could begin sooner than was expected just a few weeks ago before the banking crisis began. The Fed typically starts cutting rates before the recession starts and after the yield curve begins steepening. If the 10s/2s yield curve bottomed three weeks ago on March 8, that may confirm the first cut be as soon as July based on the historical lag from the bottom of an inversion until cuts take place.
There are reasons why there could be another change in direction, with the first cut coming as early as July, and potentially three more cuts priced in before the end of the year. One of the challenges for the Fed that could cause a change in direction is the labor market, which remains extremely tight despite the 500bps in hikes over the past year. The Job Openings and Labor Turnover Survey (JOLTS) still shows nearly 11 million job openings and 1.9 jobs for every unemployed worker. Unemployment claims have remained low with weekly initial jobless claims below 200,000 in 10 of the past 11 weeks. Although these point to a strong labor market, the question of areas of weakness across regions should not be ignored.
The shock to the banking system in March is tightening credit conditions, thus slowing growth, and could have a similar impact as further rate hikes depending on how long the tension lasts. Although the Fed anticipates another hike in their dot plot forecast for 2023, we’re not sure they are going to be able do it this cycle as uncertainty argues for a pause to assess the situation.