The macro outlook has evolved meaningfully since Federal Reserve officials last submitted forecasts for June Federal Open Market Committee meeting. The inflation picture worsened – of the 3 alarmingly hot CPI prints in recent months, only 1 was known in June. Inflation now looks stickier and broader based across components of the Consumer Price Index (CPI) price basket, wage inflation has accelerated further, and on net, inflation expectations have ticked higher. Meanwhile, the activity data has shown an economy that reaccelerated after a weak patch in May and June, while the labor market has proven particularly resilient in the face of macro developments including elevated energy market volatility and tighter financial conditions.
As a result, the Fed raised rates by 75 basis points and meaningfully adjusted higher their outlook for interest rates, for this year and next (75-100bp upward revisions for a terminal rate of 4.6%). While the Fed did not project a contraction in real GDP over their forecast horizon, it is looking increasingly likely that economic contraction, and a more meaningful move higher in the unemployment rate, is exactly what will be needed to bring down inflation. For example, recent estimates from the San Francisco Fed put NAIRU at 6%, suggesting that a larger rise in the unemployment rate is needed to re-anchor inflation.
Despite these revisions, FOMC members still viewed the balance of risks around inflation as weighted to the upside. Elevated inflation has kept real interest rates low, despite generally tighter financial conditions. And with inflation now broadening, it is much less clear that inflation will moderate on its own without additional monetary tightening to bring real interest rates above their neutral levels. Indeed, the risk of second round effects of higher inflation contributing to rising inflation expectations and so on appears more acute in the context of inflationary trends that now appear broader than just pandemic-related supply shocks.
Looking ahead to the next two meetings, we think the rate path forecasts imply another 75bp hike should be expected in November, before the pace slows in December. 75bps is the new 25bps.
