Breaking News: Federal Reserve increases interest rate 75 bps

Following June’s scorching inflation reading, the Federal Reserve raised the target federal funds rate by 75 basis points (bps), another aggressive step in the Fed’s campaign to cool the economy and bring inflation to heel. This brings total cumulative rate hikes this year to 225 bps. Our forecast of future rate hikes is almost fully dependent on inflation. As a result, we see the Fed raising rates by another 75 bps in September, followed by 25 bps hikes during the remaining two meetings of the year. By the same logic driving our 2022 interest rate forecast, we don’t see the Fed pulling back on rate hikes until inflation has fallen below 6%. In addition to rate hikes, the Fed continues to shrink its holdings of Treasury and mortgage-backed securities which is further tightening monetary policy.

The hawkish Fed will no doubt constrain economic growth in the short-term by weakening demand and tightening financial conditions. This week’s GDP report may very well indicate that the economy contracted during 2Q 2022. That would make it the second consecutive quarter of negative economic growth, which is often and incorrectly assumed to be the definition of a recession. In fact, the agency responsible for dating recessions looks not just at GDP growth, but also at the labor market, which we know to be holding up very well.

It is unclear the extent to which the Fed will be able to achieve its goals of curbing inflation while avoiding recession. This is especially true considering that the lion’s share of inflationary pressures in the economy are stemming from the supply-side, namely supply chain bottlenecks and labor constraints. Both of these two supply-side challenges are showing initial signs of easing, but clearly not fast enough for the Fed. The biggest concern from the Fed’s perspective is the possibility that inflation will become “entrenched” in consumers’ minds, which could generate the feared wage-price spiral. The latest report from the BLS shows some moderation in wage growth, but other sources—notably the Atlanta Fed—sees wage growth still accelerating. It is in this context that the Fed is particularly eager to bring inflation down.

All in all, the U.S. economy today is in a relatively strong position to withstand the current pace of interest rate hikes. This is due to strong household and corporate balance sheets, a tight labor market and a much improved and cautious banking system as compared to the years preceding the Great Recession. Although interest rate hikes of this magnitude are often associated with an economic “hard landing,” the Fed may just be able to achieve the long-desired “soft landing.”