The Fed raises interest rates sharply

The Federal Open Market Committee (FOMC) raised interest rates by 0.75% at its meeting on Wednesday, 15 June 2022. This followed the release of the May 2022 inflation data last week that showed an unexpected increase. Furthermore, recent data on inflation expectations also showed a worrying rise.

While financial markets initially expected a 0.5% increase, sentiment changed dramatically over the weekend and by Wednesday market expectations were for a 0.75% increase. That enabled the Fed to raise rates sharply without surprising the markets.

As the table below shows, the median FOMC members’ outlook for the US economy has changed markedly since its meeting in March 2022. While it has lowered its growth forecasts for this year and next, it projects the unemployment rate to be 3.7% at the end of 2022, 3.9% in 2023 and 4.1% at the end of 2024. Since the FOMC’s assessment of full employment corresponds to an unemployment rate of around 4%, it expects the labour markets to remain tight.

With inflation remaining strong, it raised its forecast for 2022 to 5.2% but continues to expect inflation to fall sharply next year and be marginally above 2% in 2024.

Central banks with a numerical objective for inflation generally project it to return to target within a few years, otherwise they would change policy to the extent needed to ensure that it did. The more important question is rather what path of interest rates the central bank anticipates will be necessary to achieve the inflation objective.

Not surprisingly given recent strength in the data, the FOMC revised up its projection for inflation sharply. Consequently, it now expects interest rates at the end of 2022 to be 3.4%, or 1.5% higher than it projected in March. It projects even higher interest rates, 3.8%, for the end of 2023, which is 1% higher than it projected in March. For the end of 2024, it revised up its projection to 3.4% or by 0.6%. This represents a sea change in expectations.

Figure 1. Median Projection of FOMC members, June 2022

Source: Board of Governors of the Federal Reserve System. Data as at June 15 2022.

Looking ahead, interest rates remain too low. The Fed faces the delicate problem of raising rates to a more appropriate level without causing a recession. A key question is whether that will be possible.

Historically, recessions in the US have been preceded by sharp increases in oil prices and by the Fed tightening monetary policy. Some commentators have argued that these recessions have been caused by the monetary policy reaction to higher inflation rather than to the oil price increase itself. While a recession is not the main scenario, the risk has plainly increased.

One indicator that helps us think about the probability of a US recession is the slope of the yield curve between 10 years and 3 months (10y-3m). This has turned negative around 12 months before every recession since at least 1962, including even the covid-induced recession in 2020. If that relationship continues to hold, then having a view on when the 10y-3m slope turns negative implicitly contains a forecast about when the US economy will experience a recession.

Taking current futures pricing to provide a forecast about the path of the fed funds rate shows that a further eight hikes are now priced in for the remainder of this year. At the same time, as the Fed hikes and the impact is felt on the economy, so the longer end of the curve typically prices in a slowdown in activity and longer yields decline.

Figure 2. Slope of the US yield curve (10y-3m) and Recession Probability

Source: NY Fed. Data as at June 15 2022. Past performance is not an indication of future results.

At the time of writing, the yield on the 10-year Treasury bond is around 3.4% and futures markets expect the Fed funds rate to rise to 2.90% by end September and to 3.35% following the FOMC meeting on 2nd November 2022. This suggests that the yield curve slope might turn negative sometime in Q4 of this year. If that were to happen, that would indicate a high probability of recession sometime in H2 2023. The probability of a US recession over the next 12 months currently priced by the model is around 5% based on the 10y-3m yield curve slope of roughly 1.8%.

There may be good reasons why this model stops working or is not relevant in the current environment and why other indicators may dominate in any particular cycle. However, such deviations are very difficult to identify ahead of time. In the absence of reasons to distrust the model, its historical forecasting accuracy indicates that the best estimate of when the US economy will enter recession is in the second half of next year. This time might be different but there are insufficiently good grounds at the moment to understand why that might be the case.