Don't get too comfortable with those 4% money market rates.
Morningstar, which is more optimistic than most pundits that the Federal Reserve will be able to beat inflation sooner than later, is predicting that the Fed will need to start cutting interest rates to restart the economy by the end of next year, Preston Caldwell, a senior U.S. economist at Morningstar, argued in a blog this week.
“We expect inflation to come down quicker than the Fed expects, which is why we expect the Fed to eventually cut interest rates more aggressively than it currently projects. Likewise, other investors now appear too pessimistic on how quickly inflation will fall,” Caldwell said.
When will interest rates go down? “First, we expect the Fed to pause its rate hikes by summer 2023. Then starting around the end of 2023, we expect the Fed to begin cutting the federal funds rate,” he said.
Caldwell expects “the Fed to pivot to monetary easing as inflation falls back to its 2% target and the need to shore up economic growth becomes a top concern."
On the federal funds front, Morningstar predicts a year-end 2023 rate of 4.75%, falling to 2% by the end of 2024.
“Further out, our 2026 and long-run projection for the fed-funds rate and 10-year Treasury yield are 1.75% and 2.75%, respectively," he said. "We do, however, expect interest rates to dip below these levels in 2025 and 2026 as monetary policy leans accommodative.”
While Morningstar still thinks the likelihood of recession remains a “serious possibility” and pegs the likelihood at 25%, “it should be short-lived if it occurs. Once the Fed wins the war against inflation, it will shift to cutting interest rates in order to get the economy moving again,” Caldwell said.
“One reason that interest rates have risen much further than most forecasters (including us) anticipated is that the U.S. economy has proved more resilient to the impact of higher rates than expected,” Caldwell said.
The Fed has raised interest rates eight times in the past year, bringing the benchmark borrowing rate to between 4.5% and 4.75%. Most recently, the Fed raised rates a quarter of a percentage point, following a 0.5% increase in December. Earlier in 2022, the Fed raised interest rates by 0.75% at four consecutive meetings.
The next rate hike is scheduled to be announced March 22 when the Federal Open Market Committee meets.
While housing activity has fallen sharply, much of the rest of the economy seems unscathed, the economist said. “We think that households’ excess savings and other factors are temporarily cushioning the hit from higher interest rates. In 2023, we expect the impact of rate hikes to be felt more strongly in other parts of the U.S. economy,” he said.
Morningstar is projecting price pressures to swing from inflationary to deflationary by 2023, owing greatly to the unwinding of price spikes caused by supply constraints in durables, energy and other areas.
“This will make the Fed’s job of curtailing inflation much easier. In fact, we think the Fed will overshoot its goal with inflation averaging 1.9% over 2023-26. If inflation becomes much more entrenched, the Fed will have to engineer a sharp short-run recession by hiking interest rates much higher than we expect,” Caldwell warned.
As long as the Fed is allowed to shift to easing by the end of 2023, GDP should avoid a large downturn and start to accelerate in 2024 and 2025, he added.
The Fed’s pivot should provide welcome relief to investors. “Rising interest rates played a key role in the selloff in both stocks and bonds in 2022. Bonds will certainly rally if yields fall in line with our forecasts for the next five years. And while not guaranteed, we expect that falling interest rates would likely also lift stock prices,” Caldwell said.
Morningstar also expects more GDP growth than other pundits. The firm is forecasting three to four percentage points more of real GDP growth through 2027 than the consensus.
“Consensus remains overly pessimistic on the recovery in the labor supply and has overreacted to near-term productivity headwinds, in our view,” Caldwell said.
Housing, which is interest-rate sensitive, will drive much of the fluctuation in GDP growth, he said. Lower rates in 2024 and 2025 will be needed to improve housing affordability and “resuscitate” demand in an ailing housing market, he added.
Why does Morningstar disagree with investors on how quickly interest rates will fall?
“Our expected path for the federal-funds rate is below what other investors are expecting, as gauged by the federal-funds futures market. The Fed’s own projections are about in line with the futures market. The difference starts small, but by the end of 2024, we expect a federal-funds rate about 2% lower than the market and the Fed,” Caldwell said.
The Fed will respond to real data, as it has many times over the past 10 years when it “veered” from initial forecasts and multi-year projections, the economist predicted.