The Federal Reserve is about to raise its benchmark interest rate for the first time since 2018, but it’s already time for the market to look past this well-telegraphed move, according to Kathy Bostjancic, chief U.S. economist at Oxford Economics.
While there are complicating factors such as the war in Ukraine, the most prominent issue for the Fed is that economic growth remains quite strong. If the Fed is shy about raising rates and reducing the balance sheet because of war, there is a risk that it gets even further behind on inflation, Bostjancic says. Consumers are still sitting on a high level of savings and benefitting from rising wages, and if the Fed gets further behind the curve on inflation by waiting, it will only increase the risk of the central bank becoming more hawkish later on.
There are risks on both sides of the Fed equation. If it is too hawkish and tightens too quickly, that can send the financial markets into a convulsion and lead to a mass selling of risk assets which feeds back into the real economy. Recent action in the bond market showing a narrowing of the spread between the two-year and 10-year treasuries stoked fears of an inverted yield curve, which is a signal that this worst-case, recessionary scenario, could play out.
But it’s not the base case for Bostjancic, even if she says the Fed won’t be blind to these signals.
Fed Chair Powell indicated during recent testimony that he sees inflation running a little faster than the Fed’s previous expectation, and any adjustment from the Fed is significant, Bostjancic said. But her view of the inflation outlook remains much higher than the median forecast of 2.7% year over year through Q4 2022 — closer to 4% than 3%. This is based on a labor market that is strong and a consumer that is resilient, and the Fed being behind the curve on inflation already.
“It is high and elevated and rising at a rapid pace,” she said. “The Fed has to worry about inflation. We’re not talking about just 3%. It’s close to 8%. This is a massive overshoot.”
The “dot plot” and the Fed’s economic projections for GDP and inflation will need to be digested by the market, but ultimately, it’s how Fed Chair Jerome Powell frames the Fed thinking on Wednesday that matters most. “I want to hear how he handicaps the risks around growth and inflation. That will tell me something about the Fed’s reaction function and that is the forward guidance,” Bostjancic said.
While oil prices and the pain at the pump, which eased this week, caught the market’s attention amid the outbreak of war in Europe, Bostjancic says food prices have double the weight of energy in the consumer price index and loom as an even larger factor in the inflation outlook — and are not immune to war. Commodities prices rising sharping are likely to get worse because of Russia’s invasion of Ukraine, which impacts the production of wheat among other commodities and will reverberate through the global supply chain and “turbocharge food prices even higher,” she said.
Powell has already said rate hikes are coming, in spite of the outbreak of war.
Oxford Economics is in line with a market view of 175 basis points of total tightening by the Fed this year, but isn’t sure whether those hikes remain limited to 25 basis points or include the potential for a 50 basis point hike at some point. “Our view is that the economy is strong enough and demand still strong enough that even with the impact from war we still see growth at 3% or higher this year, so the Fed needs to get to a neutral rate as quickly as possible without destabilizing the market,” Bostjancic said.
The situation is not “dramatically different” for the U.S.,” she said. The U.S. economy is not immune to the war, but compared to Europe’s economy, it is much better insulated. “I don’t think Ukraine necessarily slows the economy enough to take the edge off inflation,” she added.
Powell will need to provide a view on where his concern primarily lies — how does the shock of this war impacts the U.S. economy versus the shock on the inflation side and the growth side, and the market will be looking closely for any signals from the Fed chair on what he emphasizes more in the risk analysis.
But in the end, Bostjancic says, “The Fed has to come in. It can’t control the war even if there is a knock-on effect in supply chains and scarcity of food and oil occur.”
There is also no way for a central bank to project the potential for a ceasefire in war.
Even in Europe, the ECB recently showed itself to be more hawkish in inclination, holding rates but saying it would wind down stimulus sooner rather than later. “They need to fight inflation even if growth is slowing,” Bostjancic said, and the ECB’s recent policy views match an outlook on the Fed that suggests it can be more hawkish even in the face of larger uncertainty.
The war could potentially delay the Fed’s balance sheet runoff, but by a month or two, and in her view, it should not alter the general path of normalization of both rates and the Fed’s holdings in the bond market.
While this week’s producer price index showed a slight undershoot of the inflation expectation and the latest wage inflation reading came down, the recent flow of data has reinforced that the inflationary pressures are still widespread and elevated, and the Fed needs to raise rates and has the ability to raise in a significant way. “They have to come in and cool things off,” Bostjancic said.
The market has already priced in an aggressive rate hike profile, and the market is not likely to be told by the Fed to price in less than it already has. “The market is already in tightening conditions without the Fed having to do it. It’s doing the work for the Fed,” she said.