Insights + Resources

Market Update: Fed Gets Pessimistic, Yet Realistic

Sep 23, 2022

The Federal Open Market Committee (FOMC) increased the target rate by 75 basis points (bp) to a 3.25% upper bound and delivered a more pessimistic outlook in their published Summary of Economic Projections.

The Committee hiked rates at this magnitude for the third consecutive time and Federal Reserve (Fed) Chairman Powell signaled “ongoing increases…will be appropriate.” So at this point, we expect a 50 bp hike at the next meeting in November with additional hikes in the following meetings. If the economy shows resiliency and headline inflation does not ease as much as policymakers prefer, the Fed funds rate could reach 4.50% by mid-2023.

As shown in the LPL Chart of the Day, the Fed has a lot more work to do in slowing aggregate demand and thereby slowing the rate of inflation. “The Fed tightening cycle does not always induce a recession, but since the Fed is acting particularly aggressively to combat nagging inflation, we see rising recession risks in 2023,” warned LPL Financial Chief Economist Jeffrey Roach.

View enlarged chart.

Recession Risks Rising

The Fed is willing to sacrifice growth for lower inflation. Growth expectations were revised materially lower for this year and the next. The Fed’s new forecast for 2023 GDP growth is 1.2% with an unemployment rate of 4.4%. The unemployment rate could increase because the Fed pushes the economy into recession. Or, unemployment could rise because the millions of individuals still on the sidelines finally re-enter the workforce during an unfortunate time when the plethora of job openings dissipate.

The new unemployment rate forecast of 4.4% for both 2023 and 2024 seems reasonable. The economy will be better off the sooner the unemployment rate reaches the so-called “natural rate of unemployment”, which is the rate that is neither too low and inflationary nor too high and recessionary. The Fed is now more aligned with the Congressional Budget Office (CBO) estimate of the natural rate of unemployment.

Overall, the economy is on unsure footing. Chairman Powell warned that “no one knows whether this process will lead to a recession, or, if so, how significant that recession would be.”

Conclusion

Inflation may be rolling over. We are already seeing August rents decline in some markets across the U.S. and imported food prices decline, so the upcoming inflation reports could be surprisingly better than expected.[1]

The impacts from recent Fed rate hikes are being quickly passed through to the mortgage market and other credit markets. Variables to watch are auto sales, credit card usage, residential real estate and personal loan demand. Unfortunately, other areas of the real economy have yet to feel the full impact of these aggressive rate hikes. So far, recession indicators are holding up so our base case is still a soft landing but risks are to the downside, especially in Q1 of next year.

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