John W. Diamond, "The Fed Will Continue to Raise Interest Rates. But How High Will They Go?" (Houston: Rice University’s Baker Institute for Public Policy, October 13, 2022).
The Federal Reserve’s interest rate policy is a major source of uncertainty for market participants. Already, the stock market is sensitive to economic data on inflation as well as other economic data and earnings reports. But the uncertainty surrounding the Fed’s interest rates are spurring some big questions. How high will the federal funds rate go? How quickly will it rise? And how long will it stay at that level? Market participants are continually updating their answers to each of these questions using economic data that shows how the Fed’s recent rate increases are affecting inflation.
For example, the September employment data showed lackluster job creation numbers, a decline in unemployment to 3.5%, a decrease in job openings by 10% (from 11 million to 10 million) and wage growth at roughly 5%, which was slightly lower than expected. The signals in this data ultimately led to large declines in equity prices. Market participants interpreted the data as an indication that the Fed is likely to continue increasing the federal funds rate. Not only are future rate increases more likely, but it’s also likely that the Fed will raise rates higher than previously projected. The most recent inflation data on producer and consumer prices is not likely to help.
The August producer price index (PPI) numbers showed that wholesale inflation remained high at 8.7% year over year and 5.6% when looking at core inflation, which strips out food and energy. The PPI is often an indicator of the movement in the consumer price index (CPI). The latest CPI data shows that year-over-year inflation has moderated slightly to 8.2% (compared to 8.3% in August), but more importantly, core prices have increased at an even faster pace of 6.6%, a new four-decade high. This increases the likelihood that the Fed will continue to raise interest rates in its next two meetings in November and December, and that it will likely increase rates by more than market participants previously expected in an effort to reduce growth in core prices.
Markets are currently making educated guesses about the future actions of the Fed. One source of data that market participants use to forecast the future actions of the Fed is the Fed’s dot plot. The Fed’s dot plot is an unofficial projection by each of the members of the Federal Reserve Board and the Federal Reserve Bank presidents regarding the future levels of GDP growth, employment, inflation and the federal funds rate. The document is published after each meeting of the Federal Reserve Open Market Committee. Currently the median projection of the federal funds rate is 4.4% at the end 2022 and 4.6% by the end of 2023. The median projections decline to 3.9% in 2024, 2.9% in 2025 and 2.5% in the long run.
However, unexpected data on employment or inflation can lead members of the Federal Reserve to change their projections of future economic variables. For example, the president of the Federal Reserve Bank of Cleveland, Loretta Mester, recently said that given the lack of evidence in the data, the fact that the Fed’s actions are not having a significant impact implies that interest rates will need to move higher. This may indicate to market participants that rates will be higher in 2023 than previously expected. These types of changes can lead to large corrections in equity prices and bond yields to the extent that market participants update their projections about the actions of the Federal Reserve.
Increased uncertainty will continue as we move forward. But eventually, the Fed’s actions will start to reduce inflation and, as the economy begins to recover, we should reach a more stable path. However, the Fed cannot achieve stability on its own. Fiscal policymakers must adopt policies that move toward a sustainable budget. With a total debt of $31.4 trillion and a deficit of $1.4 trillion in fiscal year 2022, the time has come for our elected representatives to act responsibly and make the tough choices to put the United States on a sustainable fiscal path. Reviewing the grand bargain laid out by the Simpson-Bowles Commission would be a great place for fiscal policymakers to start.
