During its latest meeting, the US Federal Reserve kept rates unchanged, which was in line with expectations. However, there were revisions in their economic forecasts which are quite worrisome in my opinion.
For example, the Fed’s median forecast for gross domestic product (GDP) growth in the US increased from 1 percent to 2.1 percent for 2023, and from 1.1 percent to 1.5 percent for 2024, while unemployment rate forecast fell from 4.1 percent to 3.8 percent for 2023 and from 4.5 percent to 4.1 percent for 2024.
Their core projection for the personal consumption expenditures index for 2025 increased from 2.2 percent to 2.3 percent.
Finally, their projected Fed fund rate increased by 50 basis points from 4.6 percent to 5.1 percent for 2024, and from 3.4 percent to 3.9 percent for 2025.
Judging from their latest revisions, the Fed seems to believe that the US economy is very resilient and is on its way to orchestrate a soft landing. This is despite the abundance of risk factors that chair Jerome Powell admitted he was aware of such as rising oil prices, the resumption of student loan repayments, a potential government shutdown, and the United Auto Workers strike. The Fed continues to have a favorable view on the US economy most likely because the unemployment rate remains very low at 3.8 percent, while GDP growth remains strong at around 2.1 percent as of the first half of the year.
The Fed also intends to keep interest rates higher for longer. Because of the limited impact of its aggressive rate hikes so far on the unemployment rate and GDP growth, the Fed most likely believes that inflation is very sticky and will stay stubbornly high unless it employs a more aggressive response. Based on the Fed’s latest projections, this means keeping real rates (Fed rate minus inflation rate) very high in the next two years.
Although the Fed has never been very good at making projections and is known to change its policies quickly, I find its plan to keep rates higher for longer worrisome.
I don’t agree with the view that the US economy is very strong and that elevated interest rates won’t lead to another recession. Historically, every time the Fed raised rates to the point where short-term rates went above long-term rates (or the yield curve inverts), the economy suffered from a recession.
However, timing the recession is difficult because the time it took for the economy to officially enter one varied widely. Even if the US is not yet in a recession today, it does not mean it won’t happen, especially with the significant increase in interest rates and the high level of debts the government and consumers have today. Moreover, the unemployment rate is a lagging indicator and won’t increase sharply unless the economy is already in a recession.
There is also a risk that the Fed will not cut rates even if the US falls into a recession. Recall that it took a while for the Fed to start raising rates this cycle even though inflation was already increasing in 2021 because it thought inflation was only transitory.
Now that the Fed is very hawkish, I won’t be surprised if it stays worried about inflation staying elevated even if the economy is in a recession, especially since there are so many convincing arguments why inflation will stay higher for longer.
Recall that in the 1980s, former Fed chair Paul Volcker had to raise rates twice after prematurely cutting them because of a recession, as core inflation shot up again after initially going down.
Here in the Philippines, a very hawkish Fed will also influence the Bangko Sentral ng Pilipinas’ (BSP) monetary policy as the Philippines will need to maintain a comfortable interest rate differential with the US to keep the exchange rate stable. Last month, BSP Governor Eli Remolona said a rate hike was more likely than a rate cut in the next Monetary Board meeting in November. Although Remolona said that the decision to hike interest rates would largely depend on domestic inflation, which remains very high, I believe that the direction of the peso would also influence the central bank’s decision.
High interest rates are not good for economic growth as they discourage consumers from spending and businesses from investing. They are also not good for risk assets such as stocks as fixed income assets become more attractive. Because of the growing risk that interest rates will stay elevated, it will be difficult for stocks to recover sustainably in the short term. INQ