Rising Macro Risks May Limit Fed From Reaching Its Projected Peak

After hiking its policy rate at 10 consecutive meetings since March 2022, the U.S. Federal Reserve paused in June but expects more tightening ahead. Given strong recent economic data and the Fed’s revised projections, we believe this pause is likely a “skip” and that we’ll see another – and probably final – rate hike in July. Further out, our base case includes a weakening U.S. economy in late summer or fall that will likely prompt the Fed to pause hikes past July. However, if continued strong data pressures the Fed to keep hiking, the risk of a sharper slowdown will likely increase.

Fed officials are balancing the risks of high inflation, which made little progress in the first half of 2023, and the lagged effects of the 500-basis-point tightening campaign. While Fed officials have suggested they hoped to take more time to assess the impact of monetary policy, stubbornly firm core inflation and resilient labor market reports since the Fed hinted at a pause complicate its balancing act.

Hawkish pause

At its June meeting, the Fed left rates and balance sheet policy unchanged, while signaling that further rate hikes may be required. The new Summary of Economic Projections includes hawkish adjustments to the dot plot; participants raised 2023 interest rate projections such that the median dot moved up by 50 basis points (bps) to 5.6%. A significant majority (12 of 18 participants) sees at least an additional 50 bps of tightening this year, which suggests that Chair Jerome Powell and other members of the Fed’s leadership are among those expecting more hikes.

Fed officials also adjusted economic projections in a hawkish direction, and now anticipate lower unemployment, stronger growth, and stickier inflation this year, consistent with their projections that more monetary policy tightening is likely to be needed.

Interestingly, several officials slightly raised their longer-run policy estimates – a proxy for the neutral rate of interest. While the median remained unchanged at 2.5% (consistent with PIMCO’s New Neutral range), the upward revisions suggest officials may be considering whether the neutral interest rate has evolved since the pandemic.