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Recession inevitable amid Fed hawkishness; inflation will wane and rate cuts are likely in H2CY23

* The Federal Open Market Committee (FOMC) raised its policy Fed Funds rate by 50bp to 4.25-4.5% as expected at its Dec’22 meeting – following four consecutive hikes of 75bp each. During CY22, the US policy rate has consequently risen by 425bp, the biggest increase in a single year since the Fed Funds rate became the formal policy target in 1993. The Fed also reaffirmed that it would continue shrinking its balance sheet (selling part of its holding of Treasury and agency securities) by US$95bn monthly. FOMC members’ median forecast for the Fed Funds rate at endCY23 rose to 5.1% (from 4.6% previously), while their projection for real GDP growth in CY22 was raised to 0.5% (from 0.2% three months ago) and cut to 0.5% for CY23 (from 1.2% previously).

* We retain our forecast for the Fed Funds rate to peak at 5% in Mar’23. An extended period of high interest rates and shrinking money supply (M2) are needed to offset the inflationary impact of the biggest-ever 2-year increase in M2 in US history between Mar’20 and Feb’22. However, US M2 has already decelerated to 1.3% YoY growth in Oct’22, and will likely shrink YoY in the months ahead amid quantitative tightening.

* We therefore expect the US economy to enter recession in Q2CY23, as indicated both by the inverted 10-year minus 2-year yield curve and ISM manufacturing new orders (a good 6-month leading indicator of US economic activity), which has been below 50 (indicating contraction ahead) for the past 3 months. As the US economy goes into recession, the unemployment rate will rise quicker than the FOMC now expects, and the resulting slack in the economy will enable core inflation to recede much quicker than now expected by the market. We expect core PCE inflation to recede below 3.5% YoY by Mar’23 and to 2.5% YoY by Jul’23. Amid a US recession, we expect the FOMC to cut the Fed Funds rate to 4.75% at its 28th Jul’23 meeting.

The US FOMC raised the Fed Funds rate by 50bp to 4.25-4.5% (or a central rate of 4.375) as expected at its last meeting of the year. The FOMC reiterated that ‘ongoing increases in the target range will be appropriate’, while Fed chair Jerome Powell gave a broad hint at his press conference that future rate increases would be of 25bp each, unless there was a distinct deterioration in the inflation outlook. Crucially, FOMC members’ economic projections showed a more hawkish stance than in the previous published projections (from Sep’22). The Fed Funds rate is expected to reach 5.1% at the end of CY23 (vs 4.6% previously expected), declining to 4.1% in CY24 and 3.1% in CY25 (vs 3.9 and 2.9% respectively previously). Market expectations of a possible easing of monetary policy later in CY23 were thus belied. Real GDP growth for both CY22 and CY23 is projected at 0.5% each (vs previous forecasts of 0.2% and 1.2% respectively), suggesting a stronger Q4CY22, but allowing for a recession in CY23.

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