MNI INTERVIEW: Real Rate To Climb In 2023 Even As Fed Cuts

Slowing inflation will allow the Federal Reserve to cut interest rates next year without taking monetary policy out of restrictive territory, according to Marc Giannoni, who recently served as the Dallas Fed's research director.

The fed funds rate will likely peak around 5.1% early next year while core CPI slows from 6.3% to 3% by the end of 2023, said Giannoni, now chief U.S. economist for Barclays. That inflation slowdown means an even bigger rise in the "real" interest rate, he said.

With tighter policy biting and demand cooling, the FOMC will likely find it appropriate to deliver a couple of quarter-point cuts by the end of next year, he said.

"A year from now, it’ll be very painful for them to maintain a target range of 5% to 5.25%, because if things go according to our forecast, you’ll have a mild recession, some increase in unemployment, inflation quite a bit lower than now and the real rate notably higher," Giannoni said.

"In that set-up, it’ll be difficult for them to maintain their rate where it is."

2023 DOTS

It's unfortunate the December dot plot won't include a mid-2023 dot, as it is unclear whether policymakers will write in a true year-end 2023 projection or use it to indicate their projection of the peak fed funds rate, Giannoni said.

Market pricing indicates investors expect between 35 and 50bps of cuts by the end of 2023. Fed officials are loathe to signal any willingness to dial back rates because that may lead to a premature loosening of financial conditions, he said.

"It’ll be a complicated exercise," he said. "The 2023 dot should be an end-of-the-year dot, but a few members may be inclined to communicate something else."

LABOR MARKET RESILIENCE

Prices in the U.S. services sector continue to accelerate faster than policymakers want, driven by labor shortages and wage pressures that are fueling strong household income and spending, Giannoni said. To rein that in, the Fed is keen to see declines in labor demand. (See: MNI INTERVIEW: US Wage Pressures Likely To Be Longer Lasting)

Average hourly earnings jumped 0.6% last month, the most in nearly a year and double Wall Street estimates. Consumer spending gained another 0.8% in October, with inflation-adjusted spending on goods still running significantly above the pre-pandemic trend.

"They want to slow down the labor market without creating a recession that’s worse than it needs to be, and in order to do that they need to indicate they’ll keep policy tight for a long period of time so they can convince every CEO that it’s not the time to expand," Giannoni said.

"But the message is not quite getting through. Demand is still strong, and they may need to do a little more. That’s where much of the debate in 2023 is going to be."