Inflation and U.S. recession risks

The recent surge in U.S. inflation has made a mockery of interest rate projections, market-implied and professional forecasts alike.

At the start of 2022, the CME’s FedWatch tool, which uses fed funds futures contracts to infer the likelihood of changes in the key monetary policy rate, gave a zero chance of the policy rate reaching the 150 to 175 basis-point range announced at the Federal Reserve’s June Federal Open Market Committee meeting and a 99% chance the rate would remain below 100 basis points.

The swiftness with which the Fed has needed to act has continued to surprise markets; the steady release of bad inflation data has eroded faith in the Fed’s mantra that inflation pressures from supply-chain and energy-supply shocks were temporary. By March, inflationary forces had forced the Fed to flip from a dovish to a hawkish stance.

Investors and forecasters missing turning points in the policy rate is nothing new. In the three months leading up to every Fed tightening episode since the 1960s, investors rarely saw what was coming. If they did, they underestimated its impact on the path of interest rates.

However, the current mismatch between expectations and reality is larger than average, only eclipsed by the oil shock induced tightening in the 1970s.

Compared with previous episodes of Fed tightening, the sharpness in the revision to the market-implied rate path from 3-months prior to 3-months after tightening begins is second only to the first Volcker era squeeze in 1980.

In August 1979, when Volcker became chair of the Federal Reserve Board, the annual average inflation rate in the United

States was 9%. Inflation had risen by 3 percentage points over the prior 18 months and would peak around 11% in early 1980. The effective fed funds rate went from 9% in 1980 to almost 20% in 1981. Both today and in 1980 investors had to sharply revise their expectations about how much and for how long rates would be higher.

Futures rollercoaster

Another striking feature of the current environment is the rollercoaster shaped path of the futures-implied fed funds rate as of early July. The market implied path for the fed funds rate has it rising rapidly, exceeding 3.6% in March 2023, then sharply reversing to around 2.7% at the end of 2024.

The Moody’s baseline forecast for July calls for a similar path with a more protracted duration at the peak and a slightly smaller decline. Reviewing forward-implied rate paths for the Treasury curve from prior Fed tightening episodes, there is nothing quite like this path even in the high inflation periods of the 70s and 80s.

We can glean several things from the humped path of fed funds futures.

First, the hump is broadly consistent with the median projection of FOMC members, a testament to the Fed’s credibility, earned over decades of inflation fighting, and forward guidance.

Second, the path suggests market participants expect the Fed will get inflation under control in a bit more than a year and within a few years return interest rates to their neutral rate, which we and the Fed, estimate to be around 2.5%.

This is supported by TIPS implied inflation and continued low yields on long-term Treasury bonds, whose prices are very sensitive to inflation perceptions.

Furthermore, model-based estimates of the term premium—a forward-looking estimate of the amount that the return on long-run bonds exceeds the projected return from rolling over a sequence of short-term bonds—is now negative again having briefly spiked into positive territory back in March and April. Past periods with perceptions of high inflation risks in the U.S. have featured term premiums of 3% or more.

Third, the market projects a decline in the funds rate to about 2.7% at the end of 2024, which is lower than the FOMC central tendency projection of 3.4%. The futures are likely

pricing in the perception that the coming tightening has good odds of tipping the economy into recession, which would be accompanied by the Fed slashing the federal funds rate back to near zero.

A crude back of the envelope estimate of the odds of recession could be inferred from reducing the possibilities to two outcomes for the federal funds rate: no recession and a fed funds rate matching the median FOMC projection of 3.4%; or a recession and the rate going to near zero in 2024.

To match July’s futures-implied rate of 2.5% at the end of 2024 implies an odds of recession of around 25%. A statistical model driven off financial factors such as the slope of the yield curve, bond spreads, and stock market performance, also puts the odds of recession over 2 years in that range.

However, adding real economy factors and, critically, the current rate of inflation to the model pushes the odds over 50%. Either way, recession risks currently appear more salient than the risk of runaway inflation.