Thomas Costerg, Senior US Economist Pictet Wealth Management.

Federal Reserve likely still fixated on high inflation, likely no signal about the end-point

The Federal Reserve (Fed) is likely to once again deliver a “jumbo” rate hike of 75 basis points on 2 November. The fed funds target rate range should therefore be set at 3.75-4.0%. The Fed is unlikely to change its quantitative tightening programme, which continues to run in the background (its balance sheet should shrink by roughly 1 trillion within next twelve months). Despite growing political pressure, including some Democratic Senators sending open letters to Chairman Powell, and despite a deterioration in some leading growth indicators, the Fed should “stick to its guns” and continue to prioritise inflation-fighting.

Core CPI inflation data remain the Fed’s alpha and omega. Problem is that core CPI clocked in at another elevated 6.6% in September (while headline inflation was 8.2% year-on-year) and is nowhere near the start of a descent.

The Fed’s reaction function remains very backward looking and based on actual data, rather than economic models. Apart from inflation, the Fed watches particularly employment gains, which are still resilient (and Friday’s non-farm payrolls should once again echo that).

More worrying for the Fed is the stubbornness of consumers’ inflation expectations, another key piece of data for the Fed. The Michigan 1-year ahead expected inflation was a still-high 5.0% in October. This in turn feeds the Fed’s fears that inflation may be more entrenched, 1970s-style and may in our view explain why Powell is unlikely to commit to an end to Fed tightening now. The deterioration of the US housing market should be once again sidelined, as some Fed members believe it is necessary pain after the Covid19 ebullience. Others may welcome the fact it could lead to slower rents, which have been an instrumental driver of US inflation lately.

Even though Jerome Powell could allude to a slower pace of rate hikes “at some point”, we think he is unlikely to signal that the end of rate hiking cycle is near. This would be in contrast to the Fed’s neighbour to the north, the Bank of Canada, who alluded that it may stop tightening soon.

Money markets currently price a Fed peak at almost 5% by May 2023, which is well above the terminal rate of 4.6% indicated by the Fed in September.

Our conclusion is that we think it would be elusive to believe that Powell may signal that tightening is coming to an end soon. The Fed’s priority is inflation-fighting, and recent data are just not good enough. One may regret that the Fed is very backward looking, as 2023 economic prospects are getting increasingly somber. The risk of policy mistake, i.e. the risk of over-tightening, is therefore rising, especially in an environment of high debt, and shrinking market liquidity. The window for the Fed’s central scenario of a “soft landing” is getting narrower and narrower.