In recent weeks, there has been a divergence of opinion on one of the most important macroeconomic topics monitored throughout the finance industry. No, not the disappearance of Alaskan Snow Crabs, but the impossible task of forecasting the federal funds terminal rate. With futures markets currently pricing in an approximate peak rate of 5% in mid-2023, Federal Reserve officials, bank economists, and financial services firms all seem to have come to the same consensus: no one truly knows when the Fed will slow down.
For those unfamiliar with the topic, the federal funds rate is the target rate set by the Federal Open Market Committee (FOMC) for commercial banks to lend one another their excess money supply overnight. The FOMC raises this rate when employment and inflation are too high to slow down the money supply in the economy and reign in real wage growth versus inflation before it spirals out of control. This process is called quantitative tightening, or QT, and also includes the reduction of the Fed’s balance sheet which consists of U.S. Treasuries and mortgage-backed securities.
The terminal rate impacts every aspect of lending throughout the economy, as banks are forced to charge higher and higher rates to make a profit on the money that they themselves have borrowed. The trickle-down effect of the fed funds rate may be most visible to consumers who were looking to get a mortgage to purchase a home. According to Bankrate.com, the current 30-year fixed national average mortgage rate is north of 7%. This is a significant increase from the low rates consumers experienced during the pandemic, which along with an inventory shortage, helped drive up the price of homes nationwide.
The Federal Reserve began the year with its dot plot forecasting a 2022 year-end rate of 0.9%. This number was forecasted with the idea that the inflation impacting the American economy was transitory in nature. It was anticipated that as the supply chain issues stemming from pandemic lockdowns started to fix themselves, so too would the inflationary environment we were experiencing. Unfortunately, this proved to be a massive misstep, as the only thing transitory in the Federal Reserve’s purview was their original forecast. Even after three straight 75 basis point hikes, the Federal Reserve is still expected to continue this hiking pace at both their November and December meetings.
This is where things begin to get interesting. As I mentioned above, the market is currently pricing in the terminal rate hitting 5% during the middle of 2023, before the Fed makes the anticipated “pivot” to give asset prices some much needed breathing room. Federal Reserve officials’ median estimate for a terminal rate as of their September meeting was 4.6% in 2023, but after September’s hotter than anticipated CPI print, few expect this projection to hold. Wall Street’s litany of economists are equally divided, with most major firms predicting the upper range of fed funds to likely top out somewhere between 5.25% and 6%. Some dissenting money managers, such as billionaire investor Mark Mobius, are suggesting an even more extreme peak of 9%, citing the Taylor Rule as evidence.
It is likely that these recent increases in terminal rate projections are the result of many factors; namely the sticky nature of core inflation, and the anticipated increase in commodity prices, particularly oil, stemming from the onset of winter, OPEC’s recent decision to reduce production, and the ongoing conflict in Europe. All eyes will be on the FOMC’s next rate projection, scheduled for release after their December meeting, for any clues on where the terminal rate is headed and when it may start to come down. If this year has taught us anything, it’s that the Fed’s projections are as accurate as throwing darts at a moving target. We can only hope someone on the FOMC’s Board of Governors has a penchant for hitting bullseyes.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Fixed Income Analyst
Boyd Watterson Asset Management, LLC
