A Fed Rate Hike by 2023? The Fed’s Pivot Doesn’t Change Our Outlook

The Fed pitched markets a bit of a changeup when it pulled expectations for a rate hike or two into 2023 as opposed to March 2024 as previously forecast. The change sent some ripples through markets as investors recalibrated mid-term expectations and digested the Fed’s views on inflation, rates and the labor market. Since that was the predominant storyline through the week, let’s take a closer look.

WALL STREET WRAP

Powell Simultaneously Strikes Hawkish, Dovish Stance: Two big takeaways from the Fed: A first interest rate hike could come in 2023, sooner than expectations for 2024. The Fed also raised its inflation expectations for 2021 to 3.4 percent. It’s a notable pivot from a central bank that’s been in crisis-support mode for the past year. Of course, talk of rising interest rates and inflation always makes markets jittery. But Fed Chairman Jerome Powell tactfully struck both dovish and hawkish notes when discussing inflation and interest rates, two primary concerns.    

First, on inflation: Yes, the Fed raised its 2021 inflation expectations from 2.4 to 3.4 percent. However, Powell repeatedly paired mention of inflation with the word “transitory.” Supply constraints and labor shortages are indeed putting upward pressures on prices, but these bottlenecks are expected to abate as supply chains catch up and inventories are replenished. The labor participation rate should also improve as enhanced unemployment benefits expire, kids return to school and people feel more comfortable taking public-facing jobs. Prices should moderate, but Powell said it’ll take time.

On interest rates, members of the Federal Open Market Committee forecast a rate hike potentially as soon as 2023, a year earlier than prior projections. Keep in mind, this forecast simply reflects a “dot-plot” of projections from the 12-member Federal Open Market Committee. It isn’t a policy or firm target. A lot can happen in two years, and the Fed will move that data forward or back as conditions warrant.   

In the meantime, the Fed still has its work to do on the labor market front. The unemployment rate isn’t expected to fall to 3.5 percent until around 2023. Until then, Powell said there is no reason to taper its bond purchasing and other programs for now. Powell’s words last week were important, but nothing has materially changed on the ground.  

In a nutshell, Powell said a lot without saying too much. There’s inflation, but it’s transitory. A rate hike could be on the way, but there’s still a lot of work to do. Ultimately, Powell said the Fed will be guided by outcomes, not timelines or forecasts. Keep in mind, if the Fed raises rates once or twice in 2023 (or even 2022 as Federal Reserve Bank of St. Louis President James Bullard speculated Friday), that would mean the economy is doing well.

The Fed’s meeting changes nothing about our intermediate-term outlook. As we forecast earlier this year, the Fed will continue to focus on its employment mandate and remain accommodative. If the economy adds jobs at a pace of 500,000 to 700,000 a month, we’re still looking at a roughly two-year endeavor to get back to full employment. Even then, the Fed will be incredibly careful not to tighten the economy into submission — a view we’ve had for quite some time. 

Retail Sales Slow in May: Retail sales fell 1.3 percent in May as consumers pulled back on big-ticket items and spent more money on experiences. The retail sales report focuses on goods but largely excludes spending on services, which are, by far, the largest drivers of economic growth in the U.S. Consumers are getting out of the house and enjoying the reopening and summer weather.

A few more points on the data. First, April retail sales were revised higher, so we consider it a wash between April and May. Second, retail sales were still well above pre-pandemic levels in May. Finally, consumers remain flush with stimulus and cash savings. All told, we’re aren’t concerned about May’s modest pullback in retail sales.

Some of Those Bottlenecks: The data reflected some of those supply bottlenecks Powell alluded to. The National Association of Home Builders’ monthly confidence index slipped slightly, to 81 in June from 83 in May (a read above 50 indicates improving confidence). That’s the lowest level in nine months, driven by labor shortages and elevated material costs. Still, a little perspective is needed: Prior to this recovery, a read of 81 would still be the highest on record going back to 1992. So, this is still a historically high level for the index.

Room for Growth: The Conference Board Leading Economic Index (LEI) was up 1.3 percent in May to 114.5. The LEI combines 10 measures of economic activity, such as the S&P 500, consumer confidence, building permits, unemployment and more, into a single number. That smooths variability in any one index to produce a 1,000-foot view of the entire economy.

May’s improved LEI follows a 1.3 percent rise in April and a 1.4 percent increase in March. That pushes the six-month, annualized rise to 9.9 percent versus last month’s 9.1 percent increase. The U.S. and many other places around the globe are coming out of a historic health crisis. These are rare circumstances, which makes it difficult to gauge how far along we are in the business cycle. All signs seem to indicate an economy that’s charging ahead nicely, and growth may not be nearing a peak.

THE WEEK AHEAD

A Few Things We’re Watching: This week, we’ll keep an eye on existing home sales in May. Prices have been rising as demand faces limited inventories, and the data could indicate if buyers are slowing purchases in response to prices. With inflation stealing headlines, we’ll check out the PCE price index, which serves as the Fed’s official inflation gauge — that may move markets, depending on where it falls. The Markit services and manufacturing PMIs for June are due this week, and we’ll see if labor and supply challenges are impacting the outlook.

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