Fed rate hike almost certain by mid-2022

December 15, 2021

Bruce Harris

Head of Global Fixed Income Strategy

SUMMARY

At its December meeting, the US Federal Reserve’s FOMC, or Federal Open Market Committee, left the headline interest rate unchanged at 0.25% in line with market expectations. However, our reading of the accompanying FOMC commentary points to imminent rate hikes in 2022.

The dot plot, or the 18 individual committee members’ current expectation for future rate hikes, while not a committee forecast as such, was adjusted much higher and now implies three rate hikes by the end of 2022 (median 0.875%) and three additional rate hikes in 2023 (median 1.625%). 2024 also shows two additional rate hikes, bringing the Fed funds rate to 2.125%. This implies that once the Fed does start raising rates, it will be a 0.25% raise almost every quarter.

Initial market reaction in the front end was muted, with Eurodollar futures for December 24 remaining flat. Three rate hikes instead of two in 2022 was a hawkish surprise, but not exceedingly so.

From the September meeting, the Fed adjusted 2022 projected median core PCE inflation up from 2.3% to 2.7%, while 2023 remained flat at 2.3%. Of note here is the record number of committee members (15) continued to see inflation risk to the upside.

The word transitory was also dropped from describing inflation in the FOMC statement. Additionally, the statement noted: The Committee seeks to achieve maximum employment and inflation at the rate of 2% over the longer run. In support of these goals, the Committee decided to keep the target range for the federal funds rate at 0 to 0.25%. With inflation having exceeded 2% for some time, the Committee expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment

This phrasing suggests that while acknowledging that inflation is running hot, maximum employment still remains a key goal of the Fed before they begin lift-off of their rate hiking cycle, though Fed Chairman Jerome Powell later noted that rate hikes could begin prior to reaching maximum employment.

In that respect, the FOMC statement also acknowledged the risk of the COVID virus to the economy: The path of the economy continues to depend on the course of the virus. Progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation. Risks to the economic outlook remain, including from new variants of the virus.

In explaining the hawkish shift in policy, Powell noted in his press conference after that price increases have now spread to a broader range of goods and services, as well as supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation, and that price increases have been larger and longer lasting than expected.

We think the Fed is well aware of possible macroeconomic scenarios arising out of COVID and its impact on the economy, as well as the historical context in which it will be initiating its rate hike cycle. The 10-year yield is at the lowest nominal level it has ever been in history (pre-pandemic), the yield curve is already extremely flat, and negative real rates are also near their lowest in history (as measured by both realized inflation and forward-looking TIPS yields).

In our view, and specifically because we see inflation trending lower than the market currently expects, when the Fed starts raising rates, it will be patient and take a more incremental approach as declining inflation readings lessen the pressure to raise rates.

Accordingly, we expect the rate hike cycle to commence by mid-2022, with three rate hikes for next year and three for 2023, taking the Fed funds rate to 1.50%. However, the Fed may pause during this cycle if the economy shows any signs of stress, or exogenous factors such as the omicron COVID variant or other fundamental events imperil the recovery. After that, the Fed may continue raising in 2024 if warranted. Currently, the futures market is not pricing in the 2024 rate hikes.