Fed to take rates higher than previously expected; more pain ahead – Reuters poll

BENGALURU  – The Federal Reserve will hike its key interest rate to a much higher peak than predicted two weeks ago and the risks are skewed towards an even higher terminal rate, according to economists polled by Reuters.

That change in expectations came after the Fed raised rates by 75 basis points last week for the third straight meeting and foresaw going higher than it had previously thought to tame inflation, which is running over four times above target.

Since then, already battered global stocks went much deeper into bear market territory – a decline of 20 percent or more – on fears of recession and most currencies weakened further against the multi-decade high dollar.

But that is unlikely to push the Fed to switch its policy path anytime soon as Fed Chair Jerome Powell and other policymakers have remained blunt about the “pain” to come.

Indeed, more than 70 percent of economists, 59 of 83, predicted the central bank would hike its Fed funds rate by three-quarters of a percentage point for the fourth straight meeting in November, a Reuters poll taken after the Fed meeting last week showed.

The survey predicted that would be followed by 50 basis points in December to end the year at 4.25 percent-4.5 percent.

If realized, that would be the highest rate since early 2008, before the worst of the global financial crisis, and 75 basis points higher than 3.5 percent-3.75 percent predicted just two weeks ago. The forecasts are in line with the Fed’s dot-plot projection and current market pricing.

“With inflation this high, history says you need to get at it sooner and you need to follow through. The real policy mistake is not bringing inflation back down to 2 percent,” said Michael Gapen, chief U.S. economist at BofA Securities.

“If a near-term recession and a larger increase in the unemployment rate than they are projecting are needed to bring inflation down, that is not a policy error in their mind.”

A poll taken earlier this month put the probability of a U.S. recession over the coming year at 45 percent, with the chance of one occurring over the next two years at 55 percent.

Neutral level

A majority, 45 of 83 economists, predicted the fed funds rate peaking at 4.5 percent-4.75 percent or higher in Q1 2023, the same as the dot plot projection and higher than the estimated neutral level of 2.4 percent that neither stimulates nor restricts economic activity.

All but two of 51 economists who replied to an additional question said the risks were skewed towards a higher terminal rate than they currently expected.

“The Fed reinforced their commitment to whatever it takes to get inflation under control, even if that means causing some pain in the economy,” said Justin Weidner, U.S. economist at Deutsche Bank, who expects the rate to peak at 4.75 percent-5 percent.

“The short-run pain of recession would be better than the long-run pain of inflation expectations becoming unanchored.”

Also, unlike most major central banks, the Fed has backing from a strong currency and a relatively strong economy compared with its peers.

Among economists who had a view through end-2023, only 46 percent forecast at least one rate cut.

With inflation not seen below the central bank’s target anytime soon and the unemployment rate, currently 3.7 percent, expected to increase at a much slower pace than in previous recessions, a premature cut might hurt the Fed’s credibility.

More than 80 percent of respondents said once the fed funds rate reaches a peak, the central bank was more likely to leave it unchanged for an extended period rather than cut it quickly.

Rates were predicted to remain in restrictive territory until at least 2026.

“To get it (inflation) down, the economy needs to run below potential, bringing demand into better balance with supply capacity,” said James Knightley, chief international economist at ING.

“The only way the Fed can do that is to hike rates and keep policy restrictive until that is achieved.”