By: Phil Kernen
The Federal Reserve raised rates in 2022 at the fastest pace since the 1980’s when inflation was even higher. Its contribution to increasing price levels and delay in recognizing inflations severity and staying power contributed to the slow start and subsequent speedy response. The Fed’s actions have reoriented asset prices across every class, inflation is raging, and at least three reasons suggest 5.5% – 6.0% overnight rates by next summer.
Real Rates are still negative
Following its November meeting, the Federal Reserve raised the Federal funds overnight rate to 3.75% – 4.0%. Rates for longer maturities are the same or lower. The lowest of the inflation calculations followed by the Federal Reserve is 5.1% for September. With inflation higher than interest rates, inflation-adjusted or real rates are still negative, meaning a decline in purchasing power for the safest investments. The Federal Reserve may feel it has tightened monetary policy materially to fight inflation, but with negative real rates, it has only been playing catch-up. To get control over inflation, at the very least it needs to raise rates above inflation.
Inflation isn’t retreating
Despite multiple rate increases, inflation remains a significant problem for policymakers, businesses, and consumers. Evidence is growing that inflation expectations are becoming entrenched. Some inflation calculations, including food and energy, appear to have peaked last summer. However, these calculations include falling energy prices, a temporary situation. Growing energy demand from China, OPEC production limits, and declining U.S. production will push prices back up. Calculations that exclude food and energy (core inflation), seen as a more accurate and less volatile indicator of inflation, are still climbing based on rising service and housing costs. Early Federal Reserve hopes of a quick inflation retreat by the end of 2022 were quickly dashed.
The Fed knows it has more to do
Every quarter the FOMC releases its Summary of Economic Projections (SEP). In September, the median forecast for core inflation in 2022 was 4.5%, and the Federal funds rate would be 4.4% and 4.6% in 2023. All three will turn out to be too low.
Three main factors contributed to the current inflation; fiscal policy putting too much money into the economy, a central bank willing to fund rescue programs by keeping rates low and purchasing the debt of the U.S. Treasury, piled on top of constrained productive capacity. Congress will not tax back its fiscal generosity, and supply chains are still opening slowly. The Fed’s goal in raising rates is to reduce demand to better match available supply.
The Fed admits it has more to do. At the press conference following the FOMC meeting on Nov 3, Chairman Powell reported that “incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected. We have a way to go before we get to that level of interest rates that we think is sufficiently restrictive.” He didn’t rule out smaller rate hikes than the latest 0.75% increase, but he did rule out easing or pausing.
The terminal rate
In line with our thinking, Chairman Powell directed investors to focus less on the speed of interest rate increases and more on the terminal or peak rate. Following a better-than-expected October CPI, investors expect the Federal Reserve to raise interest rates by another 0.5% in December to 4.25% – 4.50%. Given the language above, the Federal Reserve will continue raising rates, though at a gradually slower pace. It is easy to see several progressions over the following four meetings between February and June 2023 that would increase the overnight rate by another 1.0% – 1.5%, suggesting an overnight rate of 5.5% – 6.0% by summer 2023. Stay tuned.