Change is blowing in the wind

The August U.S. consumer price index changes the calculus for the Federal Reserve, which is now likely to hike the target range for the fed funds rate by 75 basis points next week.

Since our September baseline forecast was updated before the August CPI, our Fed call continues to evolve. CPI has been the determining factor in the subsequent meetings of the Federal Open Market Committee. Financial markets are fully pricing in a 75-basis point rate hike this month and put the odds of a 100-basis point hike at 25%.

It’s fairly clear that the Fed is going to front-load rate hikes more than in our September baseline and the terminal rate, or the peak for the fed funds rate this cycle, will also be higher. The upcoming baseline forecast is going to factor in a 50-basis point rate hike in November (previously 25 basis points) and maintain a 25-basis point hike in December.

This would imply that the target range for the fed funds rate will likely be near 4% to 4.25%. The forecast would still assume that the Fed starts cutting interest rates in 2024 to return it to its equilibrium rate of 2.5%. This peak would be a touch below the market-implied terminal rate of 4.4%.

This may not be the exact path incorporated into the October baseline because we will need to digest the September meeting, which will include an update to the central bank’s so-called dot plot.

Though we haven’t finalized the new path, we ran a simulation through the macro model to assess the impact on the near-term forecast for GDP, unemployment and inflation. The new path for the fed funds rate reduces GDP growth by a few 10ths of a percentage point from the fourth quarter of this year through mid-2024.

The unemployment rate in the fourth quarter of next year is 0.1 percentage point higher than in the baseline. By the final quarter of 2024, the gap is 0.3 percentage point. The unemployment rate peaks in mid-2023 at 4.2%, compared with 4.1% in the September baseline. The path for headline and core inflation doesn’t change appreciably and it shaves a little off inflation, compared with the September baseline.

There would be changes to Treasury yields across the yield curve. Relative to our September baseline, the higher fed funds rate path pushes the U.S. 10-year Treasury yield 23 basis points higher by the fourth quarter of 2023. At the end of 2023, the two-year Treasury is 32 basis points above September’s baseline while the three-month yield is 40 basis points higher. By the fourth quarter of 2024, quickerreacting short-term maturities begin to converge with our September baseline path while the 10-year yield remains 22 basis points higher.

All told, there is a material risk that inflation remains higher for longer since traditional monetary policy tightening is not equipped to address the supply shocks pushing inflation higher in the U.S. The Fed could be faced with a Hobson’s choice: Push the economy into a mild recession, as in one of our scenarios, to tame inflation, or wait and cause a more significant recession, since a stagflation scenario is possible next year if the Fed is not aggressive enough. The Fed’s track record in tightening monetary policy without causing a recession is not great.