Lingering inflation will prompt the US Federal Reserve to keep interest rates much higher for longer
US Federal Reserve rate hikes will continue to hurt US growth through 2023. In an environment with narrowing growth opportunities, firms should consider streamlining product offerings toward demand-inelastic essentials, as well as seek out clients downstream from these segments and clients in less cyclical sectors, such as utilities and healthcare.
As debt market and equity market stress rises, firms should review their balance sheets. Careful capital structure management can help avoid sudden surges in borrowing costs. CAPEX projects that were viable may no longer be if they were dependent on low-cost corporate borrowing or consumer credit-driven demand.
Fed tightening will contribute to further depreciation across most developed- and emerging-market currencies in the next quarter. Tightening monetary conditions also raise the risks of widespread sovereign debt crises. Firms should continue to monitor macroeconomic and balance-of-payments outlooks for signs of instability in their key markets.
Overview
A surprise in August’s inflation data has put the Fed on an even more hawkish footing. Falling energy prices were widely expected to push core CPI inflation down in August, but instead core inflation surprised to the upside at 6.3% YOY, the first major increase since February. Combined with stubbornly tight labor market data and a lull in financial conditions over summer, this has compelled the Fed to do more to suppress demand and inflation.
The September Fed meeting raised rates to 3.25% as expected in another aggressive 75-basis-point hike. New projections on interest rates and unemployment delivered more of a shock. A median projection of a 4.6% interest rate by 2023 and a 4.4% unemployment rate signal more explicitly that the Fed is willing to engineer a recession to fight inflation.
Our View
While we see a strong chance that slowing inflation in coming months should moderate the Fed’s intended hiking path, this is unlikely to come fast enough to soften the economic blow induced by the monetary tightening that has already taken place.
However, with employment levels so far holding up well against weakening demand, and private sector balance sheets in a relatively strong position, there is a solid chance the Fed’s rate hikes will only provoke a mild recession. Unemployment might not reach the 4.4% rate projected by FOMC members, but as the Fed hikes more aggressively, the risks of a deeper recession grow. If the unemployment rate does reach 4.4% in 2023, it won’t be easy to stop there as the Fed hopes to, likely initiating a downward spiral in demand.
Base-case scenario (50% probability): The Fed implements another aggressive 75-basis-point hike in November, pushing rates to 4%. However, as demand conditions weaken, slower inflation data should allow the Fed to slow hikes to only 25 basis points per meeting starting in December. Despite signs of an economic downturn, concerns about entrenched inflation compel the Fed to hold rates at 4.25% throughout 2023.
Hawkish scenario (30% probability): With growth holding up and inflation lingering more than expected (for example, headline CPI inflation holding above 7.5%), the Fed enters another round of escalations, signaling more 75-basis-point hikes and a higher terminal rate of 5.25%. This tightens demand further, backloading deeper recession risks in H2 2023.
Dovish scenario (20% probability): Easing inflation sees a slightly softer hiking path. The Fed initially holds rates at 4.00% through Q1 2023, but pivots in June, when multiple monthly increases in unemployment rates signal the US is spiraling into a severe recession. Rate cuts are too late, as the lagged effects of hikes lock in a downward spiral in spending.
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