On Wednesday, September 21, US time, the FOMC announced the latest monetary policy, raising interest rates by 75 basis points this time, reaching 3% to 3.25%, in line with market expectations.
In fact, we think this rate hike is justified, judging from the data, the weak US retail sales/industrial production index in August, coupled with the University of Michigan’s lowered long-term inflation forecast, all suggest that inflation levels have eased. The Fed raised interest rates by 75 basis points this time, which we believe is in line with expectations and is expected to avoid the risk of a “hard landing” for the economy.
At this rate meeting, Fed Chairman Powell maintained a “hawkish” attitude, but we believe that the pace and speed of interest rate hikes still depend on economic data. If there are unexpected changes in employment, inflation and economic growth, the Fed will adjust the pace of interest rate hikes as soon as possible.
We believe that the pace of future rate hikes can refer to the level of the federal funds rate. When interest rates are below neutral (between 2% and 2.5%), “rapid” rate hikes are appropriate; “Targeted” rate hikes would be more appropriate when consumer spending decelerates; a pause in rate hikes is not feasible if the labor market is hot and inflation persists.
Market may fluctuate after September
At present, the market information is complicated and risks are constant. For the U.S., we’re seeing two sets of data that point to stark contrasts, one is that inflation is persistent and the labor market is picking up, and the other is that economic growth is slowing and the housing market is undergoing a major correction.
The external environment is also less favorable. First, as the temperature gradually turns colder, the energy crisis in Europe may continue to escalate. Second, China is also undergoing the adjustment of economic transformation. Also, the fiscal reductions in both countries were, in our view, disproportionate to the magnitude of the problem.
I mentioned earlier that the Fed is expected to raise interest rates to 3.75% to 4% by the end of 2022. At that time, the Fed will suspend interest rate hikes and observe the economic data in 2023. If inflation remains high, and the economy can maintain a reasonable growth rate If not, it may stop raising interest rates at 3.75% to 4%.
From our observations, the U.S. economy is likely to weather the storm in 2023, and price pressures other than energy and food will ease. Therefore, we expect the Fed to stop raising interest rates around 4% with a high probability, and keep it in this range for a long time.
Three scenarios for raising interest rates
I think the Fed may stop raising rates at around 4%, but beyond that is uncertain. In this economic recovery, making monthly data forecasts is more difficult than ever.
I think there are three possible scenarios in 2023, in order of likelihood: First, the neutral scenario. Terminal rates remain near 4% in 2023, while the U.S. economy weathers the storm. But economic growth has slowed significantly, below potential (ie, 1.5% to 2.0%), inflationary pressures have eased, and unemployment has risen by no more than 1 percentage point from current levels.
The second is the warming scenario. The terminal rate will rise to 5% by 2023. The key to this is that inflation remains high and the labor market tightens. Even with growth well below potential, the Fed was forced to keep raising rates. This is more likely if high wage inflation becomes entrenched and businesses continue to pass on the increased costs to consumers. Between this and intermediate scenarios, there is at least 100 basis points of upside.
Finally, there is the cooling situation. With a rate cut in 2023, the U.S. economy slips into recession early next year and unemployment rises by more than 1 percentage point. Also, inflation has slowed sharply as supply chains and demand decline. The Fed over-medicated, so it corrected its direction in the fourth quarter and began to cut interest rates, but it will not immediately drop to 0, but there will be a gradual adjustment process. There is about 100 to 200 basis points of downside between this and intermediate scenarios.
I think a neutral scenario – that is, rates around 4.0% for a relatively longer period of time – is still more likely. While some consumer prices are set to adjust in the coming months, lingering inflationary pressures and a still overheated labor market necessitate higher interest rates.
Although the United States is better off relative to the rest of the world, it cannot be isolated from the influence of Europe and China. Therefore, the rate of increase in interest rates will be limited.
A warming scenario is the second most likely outcome. I found the August CPI disturbing, rising 8.3% year-on-year from August, beating the consensus estimate of 8.1%. More importantly, service inflation continues to run high, something that hasn’t happened in a long time. Inflation uncertainty is high, and companies need to pay a salary premium to attract or retain talent.
I think high-income households in the U.S. have a lot of savings, and even if the economy is weak, companies can raise prices to get through the hard times, which will also exacerbate the time inflation remains high.