We expect the US Federal Reserve to raise interest rates twice this year and four times in 2023, taking the Fed funds rate (upper bound) to 1.75% by the end of 2023 from 0.25% currently.
The updated US interest rate forecasts reflect the major pivot by the Fed at its policy meeting on Dec 14 and 15, 2021, prompted by evidence that inflation is broadening and underscored by the meeting minutes released later.
An earlier forecast — for a single increase of 25 basis points in 2022 and two in 2023 — would have taken the upper bound to 1% at the end of 2023. However, it was published on Dec 7, predating the Fed’s meeting, in which it signalled that net asset purchases would probably cease in March 2022, and markedly changed its language on inflation.
Most significantly, the Fed described inflation as having exceeded 2% “for some time”, suggesting that recent increases have already compensated for earlier shortfalls under the central bank’s flexible average inflation targeting (FAIT) strategy announced in mid-2020. FAIT does not formally define the period over which inflation should average 2%.
The minutes indicate that most Federal Open Market Committee (FOMC) participants think the condition of maximum employment — a criterion for raising rates alongside price stability set under earlier forward guidance — will likely be achieved relatively soon.
Also, the Fed is now characterising inflation as a potential threat to a sustained economic recovery and emphasising the need to anchor expectations to avoid sharper policy tightening later on.
Previous US policy rate forecasts were already consistent with 2022 being the year in which the Fed’s focus pivoted towards combating inflation risks. Higher-than-expected inflation outturns and rising wage growth and services inflation (including rental inflation) have raised Fed concerns that inflation is broadening beyond the pandemic-related goods price shock, potentially warranting earlier or faster rate rises.
Meanwhile, continuing labour shortages amplify the risk of further increases in wage growth. Recent data showed the US labour force participation rate was unchanged at 61.9% in December 2021, while the unemployment rate had dropped to 3.9%.
We believe this year’s rate rises will come at the June and September policy meetings. The Omicron variant may delay the advent of maximum employment ahead of the March meeting. Our calculations suggest US payrolls are still about 2 million below this level.
Moreover, the interval between ceasing net asset purchases and raising policy rates will be much shorter than in 2014-15, but we think the Fed remains committed to predictable sequencing of its policy tightening measures, and will want to monitor financial market reactions after asset purchases are phased out.
The December ”dot plot”, which the Fed uses to signal its outlook for the path of interest rates, showed a median expectation among FOMC members of three increases this year, but does not constitute formal forward guidance. In this case, the move to unanimity on the need for a rate rise in 2022, from a 50-50 split at the September 2021 policy meeting, was arguably more significant.
We think the private sector is relatively well prepared for higher US borrowing costs, but our updated forecasts reinforce the prospects for higher US Treasury yields and a stronger US dollar against the euro and the Chinese yuan.
Despite increases in recent weeks, real yields on inflation-protected bonds remain historically low.
We think full normalisation could see US nominal interest rates rise to about 3% over the medium to long term, potentially pushing up global rates.