US Economy Should Be In Full Swing Before Fed Rate Hikes: Expert

It is critical for the American economy to be in full swing before the Federal Reserve starts to step on the monetary breaks and make rate hikes, an expert told Anadolu Agency on Thursday.

"I don't think the Fed should begin to raise rates until it is clear the economy has returned to full employment and inflation will remain consistently above the Fed's 2% target," chief economist at Moody's Analytics Mark Zandi said in an e-mail.

The Fed signaled Wednesday that it would raise interest rates in 2023 to tame rising inflation. Its federal funds rate projection for 2023 was revised up to 0.6%, which means it could have two rate hikes of 0.25% each.

The signal came despite there being 9.3 million unemployed workers in the US and Fed Chair Jerome Powell has repeatedly indicated in recent months that the central bank would wait until labor conditions improve and full employment is achieved.

The Federal Open Market Committee (FOMC) also raised its inflation expectation for 2021 to 3.4%, up from a 2.4% estimate made in March. Its inflation forecast was increased 0.1 percentage point to 2.1% and 2.2% for 2022 and 2023, respectively.

"Presumably because of that burst of higher inflation, the median projection now shows two 25bp [basis points] interest rate hikes in 2023, which would take the fed funds rate to 0.6% - and seven officials anticipate a 2022 hike," Paul Ashworth, chief US economist at Capital Economics, said in a note.

"We had assumed the Fed would be a little more willing to let inflation rip in favor of ensuring a 'broad and inclusive' labor market recovery -- and were only forecasting one 25bp rate hike. But we clearly misjudged the Fed's evolving reaction function and tolerance for inflation."

Zandi said the Fed is catching up with investor expectations, who have long expected three 0.25% increases in the federal funds rate in 2023.

"This is appropriate given the strong US economy which is on track to be back to full employment by early 2023, and stronger inflation which is set to settle in above the Fed's 2% target by then," he said.

The Fed raised its economic growth forecast to 7%, up from a 6.5% estimate made in March, but it did not change the unemployment forecast, which is anticipated at 4.5%.

Ryan Sweet, leading US economist at Moody's Analytics, said the Fed still views acceleration in inflation as transitory but its projections and dot plot caught the attention of markets.

"Thirteen of 18 Fed officials see the first rate hike occurring by the end of 2023, versus seven in March. The dot plot now shows two rate hikes in 2023, but it's hard to glean how aggressive this tightening cycle will be, as it hinges on how much of an inflation overshoot the Fed will stomach," he wrote in a note.

Markets' reaction

After those signals, global markets were rattled. The dollar index soared almost 1% to 91.75 on Thursday, while the euro lost more than 1% against the dollar, falling to 1.1937. The yield on the 10-year US Treasury note jumped more than 6% to 1,594% before retreating Thursday.

The Dow, S&P 500 and Nasdaq were all down more than 1% at one point after the Fed meeting with the VIX volatility index, or fear index, jumping 6.6% to 18.15.

Markets "were already pricing in two rate hikes in 2023, with the outside chance of an earlier hike in 2022," said Ashworth.

But Sweet said the Fed's dot plot "rattled financial markets, as it was more hawkish than anticipated," and markets are now pricing in the first rate hike by the end of 2022.

"The hawkish shift in the Fed's so-called dot plot led to a drop in US equity prices and a jump in interest rates across a good portion of the yield curve," he said.

"Odds are the Fed's hawks are the anxious ones and they made their voices heard at the June meeting, but the core of the FOMC, including Powell, [Fed Vice Chair Richard] Clarida and [Fed Governor Lael] Brainard, are still in the dovish camp and likely favor raising rates in 2023," he added.

Asset purchase program

The Fed said it would continue its asset purchase program where it buys at least $120 billion of bonds every month to support the markets and the economy.

Zandi said he expects Powell to signal in August that the Fed is preparing to taper bond purchases during his address to the Jackson Hole meeting -- the bank's annual prestigious symposium attended by the world's top central bankers and economists.

"He will suggest that the tapering will begin in early 2022. By then it will be clear that the pandemic has been contained in the US and the economy is well on its way to returning to full employment," said Zandi.

But Ashworth noted that Powell argued during a news conference on Wednesday that the Fed was still "a ways off" from achieving substantial progress toward its dual mandate goals that would trigger a tapering of its monthly asset purchases.

Sweet said he expects the Fed to announce tapering plans in September, and the $15 billion reduction to occur at each FOMC meeting in 2022.

"The Fed has signaled that it wants tapering to be on autopilot. Once its monthly asset purchases have been reduced from $120 billion to zero, the Fed will reinvest proceeds from maturing assets to ensure its balance sheet doesn't contract, which would be contractionary monetary policy," he said. -