Rising Macro Risks May Limit Fed From Reaching Its Projected Peak

After hiking its policy rate at 10 consecutive meetings since March 2022, the U.S. Federal Reserve paused in June, but expects more tightening ahead. Given strong recent economic data and the Fed’s revised projections, we believe this pause is likely a “skip” and that we’ll see another – and probably final – rate hike in July. Further out, our base case includes a weakening U.S. economy in late summer or fall that will likely prompt the Fed to pause hikes past July. However, if continued strong data pressures the Fed to keep hiking, the risk of a sharper slowdown will likely increase.

Fed officials are balancing the risks of high inflation, which made little progress in the first half of 2023, and the lagged effects of the 500-basis-point tightening campaign. While Fed officials have suggested they hoped to take more time to assess the impact of monetary policy, stubbornly firm core inflation and resilient labor market reports since the Fed hinted at a pause complicate its balancing act.

Hawkish pause

At its June meeting the Fed left rates and balance sheet policy unchanged, while signaling that further rate hikes may be required. The new Summary of Economic Projections includes hawkish adjustments to the dot plot; participants raised 2023 interest rate projections such that the median dot moved up by 50 basis points (bps) to 5.6%. A significant majority (12 of 18 participants) sees at least an additional 50 bps of tightening this year, which suggests that Chair Jerome Powell and other members of the Fed’s leadership are among those expecting more hikes.

Fed officials also adjusted economic projections in a hawkish direction, and now anticipate lower unemployment, stronger growth, and stickier inflation this year, consistent with their projections that more monetary policy tightening is likely to be needed.

Interestingly, several officials slightly raised their longer-run policy estimates – a proxy for the neutral rate of interest. While the median remained unchanged at 2.5% (consistent with PIMCO’s New Neutral range), the upward revisions suggest officials may be considering whether the neutral interest rate has evolved since the pandemic.

Maintaining optionality

In the press conference, Chair Powell suggested that the pause in interest rate hikes may be short-lived. We believe the Fed is endeavoring to maintain optionality to hike or skip at each meeting as conditions warrant. Slowing the pace of tightening while continuing to leave markets expecting more hikes may help keep financial conditions appropriately tight while buying more time for lagged effects of prior rate hikes to show up in the macro data.

We believe the Fed continues to see the risks of doing too little to cool inflation as greater than the risks of doing too much. While Chair Powell hinted the Fed could potentially hike at every other meeting, our forecast for macro weakening in the second half raises questions around whether the Fed will deliver all the hikes (i.e., at least two more) included in its latest projections.

Macro risks are building

Despite the recent strong data, we continue to see a two-handed U.S. economy. On the one hand, inflation data, like the labor market, has remained resilient, particularly since the previous Fed meeting in May. On the other hand, payroll growth has continued to decelerate, companies are cutting hours, and inflation sectors that have been stubbornly sticky, such as rental inflation, finally seem to be peaking.

Government policy changes are also likely to add macro volatility in the latter half of the year, potentially disrupting the U.S. economy just when Fed officials gather for the September meeting. The resumption of student loan payments in September as well as delayed tax deadlines in October are likely to be meaningful headwinds to consumption in the third quarter. While we continue to believe healthy household balance sheets can help buffer the overall economy, higher debt service costs are likely to eat away at excess household savings, reducing what has been an important support to U.S. growth.

In conclusion, our cyclical outlook still includes a recession. We believe one more hike in July will likely take the Fed to its peak for this cycle, but if stronger realized data pressures the Fed to keep hiking, then the chances of a more significant slowdown would also increase.