The Federal Reserve interest-rate forecast issued this week was more hawkish than almost anyone imagined. Despite what chair Jerome Powell acknowledged as three straight good inflation reports, policymakers now expect to hold their key rate a half-percent higher through 2024 than they envisioned in June.

X

With the Fed still indicating one more hike is likely coming this year, policymakers are forecasting that over the next 15 months they’ll cut the federal funds rate by just one quarter-point from the current range of 5.25% to 5.5%.

The purported reason is the economy’s recent surprising strength. Even with short-term rates above 5%, the Fed is making a case that the labor market and inflation will only slow very gradually.

Here’s why the Fed is wrong and it’s a good bet that both the federal funds rate and market-based Treasury yields will come down much faster than expected. Especially short-term yields more closely linked to Fed policy.

The Fed Just Threw An Anchor

The Fed guidance Wednesday represents the peak of hawkishness. Policymakers are forecasting the highest rates they possibly can without losing credibility.

We’ve been here before. In June, policymakers raised their estimate of the year-end 2023 federal funds rate by a half percentage point to a range of 5.5% to 5.75%.

Despite the Fed getting halfway there with July’s quarter-point move, Wall Street has doubted the Fed will get that high. At the moment, markets see 43% odds of another rate hike this year.

On Wednesday, Fed chair Powell sounded like he was in no rush to hike again. He stressed that policymakers “are in a position to proceed carefully,” because policy is already pretty tight.

Odds of a rate hike at the next meeting on Nov. 1 stand at just 26%. Assuming the Fed stands pat, markets may begin to doubt the hawkish guidance not only for 2023 but for 2024. The Fed surely expects that will happen. That’s why policymakers threw an anchor as far upstream as they could. They want to limit a downward drift in market-based interest rates that would counteract Fed tightening.

Consumer Spending Likely Just Had Its Last Gasp

Fed chair Powell cited strong consumer spending as the main reason to think that high rates will only modestly slow growth. That, in turn, means a very gradual descent for inflation. But the Fed is looking through the rearview mirror, and there’s good reason to think consumers are low on gas.

Consumers have been breezing along, despite an inflationary shock, bear market and rapid-fire Fed rate hikes. That’s because households stored up close to $2 trillion in savings early in the pandemic. The economy, in a sense, received its own inoculation via stimulus checks, expanded child tax credits and food stamps. Also from generous jobless benefits and a moratorium on student loan payments. But with student loan payments now resuming, all those supports for household finances have expired.

Since late 2021, households have gradually spent down the vast bulk of those savings. For modest-income households, especially, the stash of savings is gone. Now think about what that means for consumption.

More Savings Equals Lower Consumer Spending

In July, households saved 3.5% of disposable income, equal to $706 billion at an annual rate. If the savings rate returns to the pre-pandemic level of around 9%, that would mean an annual hit to consumer spending of $1.1 trillion per year.

The big question is whether there will be a catalyst for savings to rise, taking a bite out of consumption. Actually, it appears to have started already. Although the first student loan payments aren’t due until October, Treasury data shows that the payments began ramping up in August.

With interest set to resume accumulating, and student loans subject to an average rate north of 6%, borrowers may be using some of their extra savings to pay down principal. So far in September they’re running at an $80-billion annualized pace ahead of year-ago totals. Ian Shepherdson, chief economist at Pantheon Macroeconomics, suspects there’s a connection between the inflows of student loan payments and recent signs of slowing in data that tracks restaurant diners and airline passengers.

The Fed Is Still Tightening Via QT

The Fed is extrapolating strong consumption through July. However, it isn’t acknowledging that financial conditions have tightened pretty dramatically since then. The 10-year Treasury yield, which is important to setting rates for auto loans and 30-year mortgages, has surged since the end of July. It hit a 15-year high before the Fed decision and continued to rise to nearly 4.5%.

Meanwhile, households may have spent a bit more freely thanks to the dramatic S&P 500 recovery fueled by artificial intelligence stocks. From the bear-market low on Oct. 12 to the recent closing peak on July 31, the S&P 500 rallied 28%, recovering trillions in household wealth. The S&P 500 has since pulled back about 6% amid the surging 10-year yield, which also is constraining price-to-earnings valuations. A higher risk-free rate implies a lower value for future earnings when discounted back to the present.

Be sure to read IBD’s The Big Picture every day to stay in sync with the market direction and what it means for your trading decisions.

Asked about the rise in market-based government bond yields on Wednesday, Powell cited stronger growth and “more supply of Treasuries.”

Extra Supply From Fed Quantitative Tightening

Part of that extra supply comes from Fed quantitative tightening, the unloading of government-backed mortgage securities and Treasuries that the central bank bought early in the pandemic to boost financial market liquidity. The Fed is letting up to $95 billion in bonds run off its balance sheet each month.

During the spring, markets got relief from QT-related supply because the Treasury Department swore off issuing more debt to avoid breaching the limit set by Congress. The Treasury spent down its account at the Fed to get by. However, Treasury borrowing has surged anew after lawmakers agreed to lift the debt ceiling in early June. The recent upward leg for the 10-year yield began after Treasury announced it would have to issue $1 trillion in debt via public markets in the third quarter. That’s $274 billion more than estimated.

The high 10-year Treasury yield is raising the cost of borrowing to buy a car or pay for a mortgage on a new home. Consumers have more incentive to delay purchases and take advantage of high yields to save up for a down payment.

The Fed outlook appears to have ignored the impact that higher Treasury yields will have on growth and inflation. All the risk to their forecast appears to be to the downside. Keep in mind, if the economy begins to struggle under the weight of high rates, the Fed may not just cut more than expected. If the jobless rate rises above the Fed’s 4.1% target, policymakers could decide to slow or stop QT, providing additional relief to the Treasury market.

YOU MAY ALSO LIKE:

Join IBD Live Each Morning For Stock Tips Before The Open

Catch The Next Winning Stock With MarketSmith

How To Make Money In Stocks In 3 Simple Steps

These Are The Best 5 Stocks To Buy And Watch Now

What To Do Amid The Correction; Is Tesla The Next Leader To Crack?