Why the Fed’s first rate hike since 2018 isn’t key to the economy’s future

The Federal Reserve is set to raise its benchmark interest rate for the first time since 2018, but it’s already time for the market to look beyond the well-telegraphed move, according to Kathy Bostjancic, chief economist at the United States at Oxford Economics.

Although there are complicating factors such as the war in Ukraine, the more important issue for the Fed is that economic growth remains quite strong. If the Fed is hesitant to raise rates and shrink the balance sheet because of the war, there’s a risk it could fall further behind inflation, Bostjancic says. Consumers are still sitting on a high level of savings and benefiting from rising wages, and if the Fed falls even further behind the inflation curve in the meantime, it will only increase the risk that the bank central becomes more hawkish later on.

There are risks on both sides of the Fed equation. If it gets too hawkish and tightens too quickly, it can send financial markets into a convulsion and lead to a sell-off in risky assets that ripples through the real economy. Recent action in the bond market showing a narrowing of the spread between two-year and 10-year Treasuries has fueled fears of an inverted yield curve, which is a signal that this worst-case recession scenario could materialize.

But that’s not the base case for Bostjancic, even though she says the Fed won’t be blind to those signals.

Fed Chairman Jerome Powell indicated in recent testimony that he sees inflation running a little faster than previous Fed expectations, and any adjustment by the Fed is meaningful, Bostjancic said. But his view on the inflation outlook remains well above the median forecast of 2.7% year-over-year through Q4 2022 – closer to 4% than 3%. This is based on a strong labor market and a resilient consumer, and the Fed already lagging the inflation curve.

“It’s high and high and growing at a rapid rate,” she said. “The Fed needs to worry about inflation. We’re not just talking about 3%. It’s close to 8%. That’s a massive overshoot.”

A trader works as Federal Reserve Chairman Jerome Powell delivers remarks on screens on the floor of the New York Stock Exchange (NYSE) on January 26, 2022.

Brendan McDermid | Reuters

The Fed’s dot plot and economic projections for GDP and inflation will have to be digested by the market, but ultimately it’s how Powell frames the Fed’s thinking on Wednesday that matters most .

“I want to hear how it handicaps growth and inflation risk. That will tell me something about the Fed’s reaction function and that’s the forecast,” Bostjancic said.

As oil prices and pain at the pump, which eased this week, captured market attention amid the outbreak of war in Europe, Bostjancic says food prices are carrying double the weight of the energy in the consumer price index and looming as an even bigger factor in the inflation outlook – and are not immune to war. The rise in commodity prices is likely to worsen due to the Russian invasion of Ukraine, which is impacting the production of wheat, among other commodities, and will ripple through the global supply chain and “will further increase food prices”, she said.

Powell has previously said that rate hikes are coming, despite the outbreak of war.

Oxford Economics is in line with a market view of 175 basis points of all-out Fed tightening this year, but is unsure whether those hikes remain limited to 25 basis points or include the potential for a 50 basis point hike. at one point. “Our view is that the economy is strong enough and demand is still strong enough that, even with the impact of the war, we still see growth of 3% or more this year, so the Fed needs to achieve a neutral rate as quickly as possible without destabilizing the market,” Bostjancic said.

The situation is not “radically different” for the United States,” she said. The American economy is not immune to war, but compared to the European economy, it is much better insulated. “I don’t think Ukraine is necessarily slowing down the economy enough. to mitigate inflation,” she added.

Powell will have to give a sense of where his main concern lies – how does the shock of this war affect the US economy versus the shock on the inflation side and on the growth side, and the Market will be watching closely for any signal from the Fed Chairman that he is placing more emphasis in risk analysis.

But in the end, says Bostjancic, “The Fed has to step in. They can’t control the war even if there is a ripple effect on supply chains and a shortage of food and oil occurs. “

There is also no way for a central bank to project the potential for a wartime ceasefire.

Even in Europe, the ECB has recently been more hawkish, holding rates but saying it will end the stimulus as soon as possible. “They have to fight inflation even if growth is slowing,” Bostjancic said, and the ECB’s recent policy views fit an outlook on the Fed that suggests it can be more hawkish even in the face of greater uncertainty. .

The war could potentially delay the liquidation of the Fed’s balance sheet, but by a month or two, and according to her, this should not change the general trajectory of normalization of rates and Fed holdings in the bond market.

While this week’s producer price index showed a slight understatement of inflation expectations and the latest reading for wage inflation fell, the recent data stream has reinforced the fact that Inflationary pressures are still widespread and elevated, and that the Fed needs to raise rates and has the ability to raise significantly. “They have to come in and calm things down,” Bostjancic said.

The market has already priced in an aggressive rate hike profile, and the Fed is unlikely to tell the market to price in less than it has already done. “The market is already in tightening conditions without the Fed having to. They are doing the work for the Fed,” she said.

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