By: Tiffany Wilding, Managing Director and Economist

What Happened? The U.S. Federal Reserve kept policy rates steady, and signaled their intent to keep rates restrictive for longer than previously thought. Real GDP growth has been much more resilient, resulting in substantial revisions to the Federal Open Market Committee (FOMC) members economic projections. The new projections imply a notable acceleration in productivity and higher short-run natural rate of interest, which brings inflation back down without much increase in the unemployment rate, or below trend growth.

What Does It Mean? The pandemic and government response has created a very unique set of factors that are impacting the US economy. Historically, when rates have risen this high, this quickly, in order to bring inflation back to the Fed’s 2% target, the economy has tended to fall into recession. Up until today, the Fed officials have implicitly admitted this fact by forecasting an unemployment rate rise that historically has been associated with recession. However, with these new forecasts, the Fed illustrated its growing confidence that this time is different.

What Is Next ? We are more concerned about the near-term sustainability of the recent 2% real GDP growth rate. While a soft landing is certainly possible, i.e., bringing inflation back to target without causing a recession, we think the probability of recession is a coin toss. Tight monetary policy is expected to remain in place for an extended period and slow economic activity over time. Positive economic overhangs from the pandemic, including elevated household excess savings, are being depleted, and this have likely lengthened the lags through which monetary policy works, not eliminated them. Credit conditions are tight, and borrowing costs are higher for the marginal borrower. The economic drags from this are expected to build overtime, as more debt is rolled over at these new higher rates.