Thomas Costerg, Senior US Economist Pictet Wealth Management.

We as well as most market participants expect another 75 basis points rate increase after the Fed’s scheduled policy meeting this Wednesday.

The reason for such a steep rate increase is the ongoing malaise about stubbornly high inflation as CPI index was up more than 9% year-on-year in June.

Nevertheless such a big rate hike underlines how backward looking the Fed’s reaction function may be. Indeed, most economic indicators as well as the recent abrupt descent in global commodity prices point to slowing inflation ahead. Importantly, economic activity is also slowing sharply and may bring down inflation with it. The main risk at this stage is in fact an inflation ‘overkill’ with monetary tightening too abrupt, unnecessarily pushing up the unemployment rate well above what’s needed to reduce inflation. We think the Fed may under-estimate the sensitivity of the US economy to interest rates, and the second issue is the likely inertia in rates’ impact on the economy. It takes several months to impact the economy, hence in general why the Fed needs to be forward rather than backward looking.

Of course, the Fed is under sizeable political pressure from the Biden administration to tackle inflation, even though we think the roots of it are to be found in budgetary, trade and geopolitical sources that are mostly beyond the Fed’s control (although we could still believe the Fed should have maybe hiked rates earlier than 2022).

There is a debate as to whether the Fed is implicitly aspiring for a recession to bring down inflation. We don’t think the Fed sees it that way. We think the Fed still does not believe that a recession is around the corner. It’s just that the Fed is focused on labour market indicators, which had held up well until now, whereas the source of the coming recession is to be found in residential real estate, firms’ de-stocking, and a likely sudden halt in business investment as sentiment sours. The labour market is in fact a lagged indicator and the ‘last shoe to drop’.

We will not necessarily extrapolate too much from the post-meeting press conference as the Jackson Hole seminar is to take place in late August, and everything could have changed by then. Indeed, then we expect the Fed to pivot and focus more on growth indicators (and rising recession risks) as well as be more forward looking about inflation. In essence, we expect hawkish rhetoric to be diluted. We therefore think the next move in September will be a much smaller rate hike of 25bps.

The labour market is likely to deteriorate towards year’s end, and we think a rise in the unemployment rate will be a red flag for the Fed and a reason to halt, especially as wages and inflation should plunge. We do not expect additional rate rises in 2023 as we expect a mild recession to happen, with the unemployment rate likely ticking higher. After a budget deluge in 2020-21, the question is whether such sharp monetary tightening – including Wednesday’s 75bps rate hike -- may represent policy over-steering, if not a policy mistake.