- Michael Luzzetti of Deutsche Bank now thinks US interest rates will peak at 5.6% later this year.
- Luzzetti had the highest rates forecast on Wall Street, and just raised his projection further.
- He says new data shows that the Fed’s huge rate hikes haven’t done much to tame inflation so far.
Inflation may have peaked in the US, but that doesn’t mean it’s going to come down in a hurry. Deutsche Bank says evidence is piling up that there’s a long way to go.
After the government reported that prices rose 6.4% in January, a bit more than experts had anticipated, Deutsche Bank Chief US Economist Matthew Luzzetti said it’s becoming clear the Federal Reserve hasn’t made much progress in taming inflation so far.
The Fed raised interest rates rapidly in 2022, using unusually large rate hikes for much of the year before tapering off to more typical 25-basis point increases. Rates were near zero a year ago, and now the benchmark US rate is 4.5% to 4.75%. Experts think rates will rise at least a bit further from there, though not too much.
But Luzzetti says the central bank will keep raising rates until July, and that US rates will peak at 5.6%. That’s above his previous forecast of 5.1%, which he described as the highest on Wall Street.
“These developments support our base case for a recession rather than a soft landing,” he wrote in a recent note to clients. “Firmer near-term underlying strength in the economy also suggests that the timing of recession could be pushed into Q4 and the first rate cut could slip into early 2024, both somewhat later than previously thought.”
Luzzetti also pushed back on the idea that the Fed might start cutting rates in the second half of this year, something investors have been hoping for as part of a ‘soft landing’ where the economy keeps growing.
Here are the three reasons why he thinks the new report means both more rate hikes ahead and a greater chance of a recession.
(1) Labor market strength
The Federal Reserve has been raising interest rates since March 2022, but the job market remains remarkably strong, with unemployment at historic lows and wages continuing to climb.
“The labor market is so far remarkably resilient to Fed tightening,” Luzzetti wrote. “Average hourly earnings have yet to show a convincing deceleration below 4.5% and the quits rate continues to signal wage growth running above pre-covid trends.”
Those higher wages are contributing to inflation, and he said that will only push the Fed to raise rates higher to make the dents in hiring and economic activity that it wants to make in order to bring inflation down to its long-term 2% target.
(2) Slipping backward
Inflation hit 40-year highs in 2022, and many measurements of price increases have improved since then, meaning prices aren’t going up as much. That might seem like progress, but Luzzetti said that some of that progress has been an illusion.
He wrote that the core consumer price index, which leaves out volatile food and energy prices, appeared to improve over the last few months — but in January, the government revised its data, and those updates wiped out most of the change.
“Recent revisions to the CPI seasonal factors showed much less disinflation in the last few months of 2022 than previously believed,” he said. “All of the key data points that had given the Fed some comfort that the labor market was slowing – declining average workweek, softening trend in temp workers, and falling job openings – completely reversed with the recent data.”
He added that core CPI data actually showed more inflation in January than in December, and now it looks like any improvement has “stalled.”
(3) Hanging loose
The Fed is aiming to reduce economic activity by tightening financial conditions, and it’s trying to do that with higher interest rates and by letting financial conditions get tighter. That should reduce borrowing and spending over time.
But that, too, is only happening slowly. So far, conditions probably haven’t tightened enough on their own for inflation to come down further. That means the Fed can’t stop now, as conditions might turn more neutral later this year.
“If the Fed wants to deliver a “sufficiently restrictive” stance to keep growth well below potential over the coming
quarters, which is likely a necessary condition for having inflation come all the way back to target, they will therefore need to ensure that financial conditions remain tight,” Luzzetti wrote.
He said that means the Fed will need to produce significantly tighter financial conditions, since the steps it has taken up to this point haven’t produced the response it wants.
“If financial conditions remain easy, particularly in the context of labor market momentum and a less convincing disinflationary trend, the terminal rate could need to push towards 6%,” Luzzetti said.