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Fed quickened its hiking pace while pledging that there’s more to come. In a widely expected move, the Fed hiked its Fed funds target range by 0.75% last Friday, the largest rate increase in 28 years, in response to stronger-than-expected reads on inflation. In its meeting statement, the Fed omitted an earlier reference that it expects the jobs market will remain robust, signaling a willingness to tolerate higher unemployment to quickly bring inflation under control.

Looking ahead, Fed Chair Powell said the committee is likely to raise rates by 0.50% or 0.75% at its July meeting, aiming to push the Fed funds rate into restrictive territory by the end of the year. The Fed’s refreshed economic projections shed light on how it expects growth to slow and the unemployment rate to rise as they continue to hike rates: The Fed’s voting members raised their forecasts for the year-end fed funds rate dramatically – from the 1.9% forecast seen back in March to a median 3.4% – implying that we’ll see another 1.75% of tightening this year. Showing that it now sees a much bumpier soft landing than previously expected, the Fed now forecasts that the unemployment rate will rise from 3.7% at year’s end to 4.1% in 2024; economic growth forecasts were cut to 1.7% in 2022 and 2023, from 2.8% and 2.2% back in March. Fed officials still expect inflation to moderate significantly in 2023. Finally, the Fed reiterated the plan to shrink its balance sheet by $47.5 billion a month, stepping up to $95 billion in September.

Our take: Slammed by critics for not anticipating the fastest rise in inflation in four decades and then for being too slow to respond to it, the Fed came out swinging last week. It admitted, in no uncertain terms, that it has an inflation problem, and is prepared to hike rates aggressively to eliminate it, even if that means higher unemployment.

The billion-dollar question now: Just how much will the Fed hike? That depends on the path of inflation, and on Fed members’ views on monetary policy. While Chair Powell avoided discussing where the Fed funds “neutral” rate lies – the level that neither constrains nor propels economic activity –  it seems that most Fed members believe that holding the Fed funds rate slightly above neutral is just the remedy needed to exert sufficient downward pressure on inflation.

While there is more than one path the Fed can take to get the Fed funds rate to its seemingly desired 3.4% by the end of the year, we think the Fed’s most likely route is for another 0.50% hike in July, a 0.50% hike in September, and a real possibility of 0.25% hikes in both November and December. The fly in the rosé? The US economy is already slowing; the Atlanta Fed expects economic growth to be 0% in Q2. Assuming the Fed sticks to its guns and continues down the hiking path, it will be hiking aggressively into a sharp economic slowdown. That tells us that it will stop short of the 1.75% in additional rate hikes this year, perhaps hiking only 1% more before pausing to assess the broad economic recession that’s likely to unfold over the coming quarters.

Other central banks joined the Fed’s inflation fight – should you care? The European Central Bank (ECB) held an emergency meeting in response to widening spreads between yields on bonds in countries at Europe’s core, such as Germany, and those on its periphery, such as Italy. The expression of concern by the ECB eased market fears that looming rate hikes and the end of quantitative easing will lead to further fragmentation in the European bond markets.

Elsewhere, the Bank of England (BoE) raised rates for the fifth straight meeting, bringing the bank rate up to 1.25%. Further hikes are expected despite a sharp slowdown in growth in the UK as consumers struggle with surging food and energy costs. Switzerland surprised markets by raising rates for the first time since 2007, as Taiwan and Hungary also hiked rates last week. The moves turned focus to the Bank of Japan (BoJ), the other major central bank with exceptionally loose monetary policy. Unlike other central banks, which are tightening policy, the BOJ held rates steady and reaffirmed its commitment to cap 10-year Japanese government bond yields at 0.25%. With global interest rates surging, the BOJ has been the outlier, maintaining its super-loose monetary policy, which has led to a dramatic weakening of the yen. Why it matters: The mostly united inflation-fighting front among the world’s leading central banks creates a tailwind for the Fed to continue down the hiking path without fear of disrupting the global economy in the process.

Economic data confirms slowdown fears – do they imply that a recession is around the corner? Retail sales fell 0.3% in May, weaker than the consensus estimate of a 0.1% gain. Together with May’s elevated read on inflation, the weak result means inflation-adjusted retail sales may have fallen about 1.4% in the month. The April-May average is tracking at an annualized decline of nearly 2% versus the Q1 average. As retailers start receiving large shipments of goods that were in high demand during Covid lockdowns, there will be stronger incentive to cut prices as demand moderates. That will likely keep overall retail spending under pressure in the months ahead.

Elsewhere, Industrial production advanced 0.2% in May – vs. 1.4% prior – weaker than the 0.4% consensus estimate. The slowdown in factory output in May highlights the Fed’s difficult balancing act as it aims to tamp down demand pressures to align them with restricted supply. If factories pull back on production plans amid economic uncertainty, it will take longer for goods inflation to calm down.

All told, while the data don’t imply a recession is looming, economic growth is indeed slowing as consumers – whose spending habits drive 70% of US economic activity – are consistently scaling back on their purchases.  Slowing factory output (lower supply) will aid in keeping prices elevated, further exacerbating a fall in consumer spending.