Fed will need help elsewhere

electricity production.

The tightening in U.S. financial market conditions recently will help the Fed cool the economy, but a more significant tightening is likely needed. Financial market conditions are the primary channel that money flows through to economic activity.

Financial markets are already pricing in an aggressive Fed that will front-load interest rates, returning the fed funds rate to its neutral rate by the end of this year.

A number of indexes that we track have shown that financial conditions have tightened, but the Fed is going to need more if growth is to slow enough to tame inflation and prevent the unemployment rate from falling too low.

The unemployment rate is close to its pre-pandemic rate and signs point to it falling even further over the next few months. This complicates the Fed’s job. There has never been an increase in the unemployment rate of more than 30 basis points, on a three-month moving average basis, that wasn’t associated with a recession.

Once the labour market overshoots full employment, it is extremely difficult for the Fed to pull off a soft landing, since the overshoot would then require the unemployment rate to rise. In that situation, returning the unemployment rate to its full employment level without a recession would be challenging.

The Fed’s latest Summary of Economic Projections has the unemployment rate averaging 3.5% in the fourth quarter of this year and next, even as it expects above-potential GDP growth.

The Fed could be anticipating further increases in the labour force participation rate, which would keep the unemployment rate relatively flat.

However, the unemployment rate has been dropping noticeably faster than the Fed anticipated since the end of the recession.

The Fed’s SEP has real GDP growth of 2.2% next year and 2% in 2024. This is above its estimate of potential GDP growth of 1.8%. To cool inflation, the Fed will likely need GDP growth closer to 1%, if not lower, in each of the next two years. Therefore, the Fed will want financial market conditions to tighten further to help take some of the steam out of the economy.

Reducing GDP growth in each of the possible. Our past work has shown that a 10% decline in the S&P 500 plus a 100-basis point increase in the 10-year Treasury yield reduces GDP growth over the course of a year by roughly 1 percentage point.

Options for the Fed include raising the target range for the fed funds rate more quickly—there have been rumblings of a 75-basis point rate hike. The Fed could also signal that the terminal rate this cycle is higher than previously thought.

But what the Fed will likely lean on first is its balance sheet, which it could use to tighten financial market conditions.