Fed to turn up the hawkish rhetoric

When the Federal Open Market Committee (FOMC) meeting concludes this Wednesday, we expect the Fed to ratchet up its inflation-fighting rhetoric by another notch or two. In addition to raising rates by 75 basis points, we expect the FOMC’s economic projections to indicate more rate hikes, slower economic growth, and higher unemployment.

Generally speaking, recent economic data has not been strong. Last week’s retail sales data had negative implications for the pace of consumer spending, and the Atlanta Fed cut its GDPNow tracking estimate for 3Q GDP growth to just 0.5% annualized, down from 1.3% previously. This follows negative GDP growth in both 1Q and 2Q. These certainly aren’t the sort of numbers you would normally associate with aggressive rate hikes from the Fed. If anything, you would expect the Fed to be cutting rates in an attempt to boost growth.

However, it’s important to keep in mind that the Fed only cares about economic growth to the extent that it affects their two mandates, which are price stability and full employment. In these two areas, recent data has surprised to the upside. Last week, falling gas prices helped to limit headline CPI inflation to 0.1% month-over-month, but core CPI showed a big 0.6% increase, which was far higher than expected. The broad-based nature of this increase raised fears that inflation is becoming entrenched. We still think that underlying trend is toward slower inflation, but at this point it does not appear as though the Fed is on track to hit it’s 2% inflation target on an acceptable timeframe.

On the labor side, the latest data showed job openings increasing and payrolls rising at a solid pace, suggesting that demand for labor remains strong despite the 225 basis points of rate hikes implemented so far this year. The good news is that average hourly earnings were up by a relatively modest 0.3% month-on-month in August, and the unemployment rate ticked higher as the labor force participation rate improved. Overall though, the data indicates that the labor market is still way too tight and wage growth remains too rapid to be compatible with 2% inflation in the long run.

All of this is likely to force the Fed to hike rates further into restrictive territory and to keep rates high for longer. In the post-meeting press conference, we expect Fed Chair Jay Powell to send a very clear message, just as he did in his recent Jackson Hole speech. The Fed is committed to restoring price stability and will not hesitate to use its tools to accomplish that. Up until now, Powell has expressed optimism that inflation could be brought down without a hard landing for the economy, and it will be interesting to see if he changes that message this time.

Our base case calls for additional 50 basis point rate hikes at the November and December meetings, bringing the Fed Funds rate above 4% by year-end. We remain hopeful that inflation will slow sufficiently for the Fed to go on hold in 2023. While service price inflation is likely to remain high in the near term, led by shelter, we expect goods price inflation to slow sharply, led by declines in over-heated items such as used cars. Wholesale data shows used cars prices already down by more than 10% from their peak, but they have barely budged in the CPI data, sitting more than 50% above pre-pandemic levels.

It goes without saying that rapid Fed rate hikes creates a difficult environment for financial markets. The market is already pricing more hikes than we expect, with the implied Fed Funds rate around 4.25% at year-end and a peak near 4.5% in early 2023.

With uncertainty remaining elevated, we see limited broad market upside out to June next year, making it important for investors to add selectively to exposure. We favor defensives, quality income and value.

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