The Federal Reserve (Fed) announced on September 21 that it had raised interest rates by 75 basis points (bps), or three-quarters of a percentage point.
The decision came a day after the Federal Reserve Bank of Atlanta lowered its much-watched estimate of third-quarter 2022 GDP (“GDP Now”) to just 0.3% on September 20, after residential fixed investment disappointed, printing at -1.28%, when the Atlanta Fed had expected it to print at +0.3%. (Move the cursor over each bar, here, to see the interaction of the “GDP Now” elements.)
The 75 basis point interest rate hike was widely priced into the market, and most observers expected it. Some were anticipating – and fearing – a 100 basis point or 1% hike. Nonetheless, the market reacted negatively to the rate hike and the Dow Jones Industrials Average fell 1.7%. The benchmark S&P 500 index fell by the same percentage.
It seems what has troubled the market is the Fed’s disappointing so-called ‘dot plots’, officially the ‘Summary of Economic Projections’, also released on September 21, which is prepared by members of the Federal Open Market Committee, Fed policy. -make the arm, and their staffs.
Dot charts are essentially predictions as to the future direction of the economy at year-end in the current year and the next three years and longer term, by analyzing Gross Domestic Product (GDP ), unemployment, inflation and interest rates.
None of the projections are good. As seen in the rightmost set of columns, the range of GDP has increased from minus 0.3% in 2023 to 2.6% in 2024. This is called the “central tendency”, where the most estimates tend to be (top three and bottom three discarded) – and the best estimate, in my opinion – showed GDP growth of no more than 2%.
I can’t help but think that even the central tendency range of the estimates is optimistic. I suspect inflation will have a longer tail than the 2023/2024 dips that the central trend would indicate. I expect that a federal funds rate, the rate the Fed charges member banks, will need to be in the 5-6% range to bring the inflation rate down, especially if the strength of employment (which we attribute mainly to a low labor force participation rate) continues. (The 5-6% we think is needed is the rate to hold inflation steady at the Fed’s preferred rate of 2%; it’s what Fed watchers call the “terminal rate.”)
The other aspect of reducing inflation is reducing the Fed’s balance sheet. While the Fed increased the burn-off of Fed assets to $95 billion this month, we have long felt that this amount was insufficient. The assets – made up of treasury bills and mortgage-backed securities (MBS) – can be sold instead of “burned”. Fed Chairman Jerome Powell has not ruled out the possibility, at least for MBS, but not at this time, he said. Selling the MBS would reduce the cash balance in the economy, which creates some liquidity risk, but also reduces inflation.
One aspect of continued rate hikes will be that the US dollar will continue to dominate currency markets. For multinationals, this will lead to a reduction in income from overseas as income is converted. As we wrote about earlier this week, companies like Federal Express will experience these kinds of translation losses as well as margin pressure.
We are revising our GDP estimate for this quarter to -0.5%.
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