U.S. Outlook: How Many More Times, Fed?

Don't fight the Fed. The well-known, but sometimes not-heeded, expression was originally coined by my first boss and mentor, the late-great Marty Zweig. Jerome Powell, the current chair of the Federal Reserve, has been doing (or trying to do) yeoman's work getting "the market" to fully digest what the Fed feels is necessary to bring inflation down meaningfully and sustainably. Powell, among other Fed officials, has seemingly shifted his attention from the rear-view mirror to the windshield. Inflation is a lagging indicator, but the impact of monetary policy changes is in the future (with long and variable lags).

This outlook—which is longer than usual (sorry!)—was published a couple of weeks prior to the December meeting of the Federal Open Market Committee (FOMC)—with current expectations showing a higher likelihood the Fed will raise the fed funds rate by 50 basis points, but a small chance of another 75-basis-point hike. That would bring the year-end rate to either a range of 4.25% to 4.5%, or 4.5% to 4.75%. However, importantly, the combined impact of what has been record aggressiveness in terms of rate hikes and the ongoing reduction of the Fed's balance sheet (QT, or quantitative tightening), means the effective tightening is greater than if only the rate side were taken into consideration.

Proxy rate

As per recent research by the Federal Reserve Bank of San Francisco, when the FOMC "uses additional tools, such as forward guidance or changes in the balance sheet, these policy actions affect financial conditions, which the proxy rate translates into an analogous level of the federal funds rate." The Proxy Rate, shown below, "can be interpreted as indicating what federal funds rate would typically be associated with prevailing financial market conditions if these conditions were driven solely by the funds rate."

Proxy rate > effective rate

A recent study from the San Francisco Federal Reserve shows that a proxy fed funds rate—which takes into account forward guidance and changes in the Fed's balance sheet—is much higher than the current effective fed funds rate.

Source: Charles Schwab, Federal Reserve Bank of San Francisco, as of 10/31/2022.

The proxy rate can be interpreted as indicating what federal funds rate would typically be associated with prevailing financial market conditions if these conditions were driven solely by the funds rate. The effective funds rate is the interest rate depository institutions charge each other for overnight loans of funds.

Given the tightening already in play, with the proxy rate north of 6%, there is a risk of a Fed overshoot. That would be the scenario that could bring rate cuts sooner rather than later. But it would likely only occur with a more significant deterioration in the labor market and/or the broader economy. The Fed is unlikely to pivot to rate cuts simply due to inflation continuing to recede. Perhaps the best way to think about next year is this: more pain near-term could result in an easier Fed in the latter part of the year; but less pain near-term likely results in tighter-for-longer monetary policy. Getting the best of both worlds does not appear to be in the cards.