[Turning Point Approaches] Final Interest Rate This Year... When Will the Fed Change Direction?

[Asia Economy New York=Special Correspondent Joselgina] One of the biggest concerns for the global economy this year is how long and how much major central banks, including the U.S. Federal Reserve (Fed), will continue to raise benchmark interest rates. Having raised rates at an unusually rapid pace last year and with inflation gradually stabilizing, attention is focused on the ‘interest rate inflection point’ expected within the year.

In particular, the Fed’s monetary policy draws the most attention as it significantly impacts the global economy overall. Wall Street expects the U.S. terminal rate to reach 5.0?5.5% in the first half of this year. Notably, six out of ten investment banks anticipate the Fed will pivot to cutting rates in the second half of the year.

Jerome Powell, Chairman of the U.S. Federal Reserve (Fed) [Image source=Reuters Yonhap News]

◇ U.S. Interest Rate Peak in First Half... Pivot Expected

Last year, the Fed raised the benchmark interest rate seven times, totaling an increase of 4.25 percentage points, and has signaled additional hikes in the new year. Nine out of ten leading Wall Street investment banks expect the Fed to raise the terminal rate to between 5.0 and 5.5% by March to May this year. This means the current U.S. rate of 4.25?4.5% will be increased by at least 0.5?0.75 percentage points.

Specifically, Nomura and JP Morgan forecast a 5.0% terminal rate in March (upper limit basis), Barclays, Bank of America (BoA), and Wells Fargo project 5.25% in March. Deutsche Bank and Goldman Sachs expect 5.25% in May, while TD and Citi anticipate 5.5% in May. Morgan Stanley was the only one among the ten to forecast a rate in the 4% range, predicting 4.75% in February. Earlier, the Fed’s December dot plot indicated a rate range of 5.00?5.25% (median 5.1%) for this year.

Interest Rate Outlook of Major Investment Banks

The key issue is the timing of the pivot (direction change). Although Fed Chair Jerome Powell drew a line in December last year by stating, "We are not considering rate cuts in 2023," pivot bets are spreading on Wall Street. This is because the downward trend in soaring inflation has become clear, and concerns have grown that excessive tightening could unnecessarily trigger a recession. However, opinions differ significantly on timing, with some expecting rate cuts starting in the second half of the year, while others foresee maintaining high rates for a while before cutting in 2024.

Among the ten leading Wall Street investment banks, six expect rate cuts this year. Morgan Stanley, Barclays, BoA, Deutsche Bank, and TD foresee U.S. rates peaking between March and May and then being cut in the fourth quarter. Nomura expects rate cuts even earlier, in the third quarter. In this case, the U.S. interest rate for this year is expected to follow a ‘high first, low later’ pattern. Barclays emphasized the possibility of a pivot within the year, stating, "If inflation slows to around 3?4%, market attention will shift from inflation to recession."

Among the six investment banks expecting rate cuts this year, five?excluding Morgan Stanley?anticipate a recession. If a recession occurs, inflation and the labor market will sharply contract, forcing the Fed to cut rates. Especially, the faster and more intense the recession, the earlier the pivot could come. This is why market investors currently do not rule out the possibility of a pivot within the first half of the year.

Jeremy Siegel, a leading bull on Wall Street and professor at the University of Pennsylvania’s Wharton School, previously stated that the Fed’s tightening is excessive and that the Fed, which has shown inconsistent monetary policy forecasts, is likely to move in the opposite direction again in 2023. He mentioned, "I would not be surprised if rates fall to 2%."

On the other hand, voices saying a pivot within the year is difficult are also growing. There is still a long way to go to reach the 2% inflation target, and considering the overheated labor market and high wage increases, there are concerns that high inflation could become entrenched. Goldman Sachs’ Chief Economist Jan Hatzius forecasted, "There will be no rate cuts before 2024."

Powell’s repeated stance that "‘over-tightening’ is better than ‘under-tightening’" also dampens pivot expectations. He cited failed cases from the 1970s, warning, "Historically, monetary policy should not be eased too early." Shima Shah, Chief Global Strategist at Principal Asset Management, predicted, "Unfortunately, even if a recession materializes, the Fed’s rescue (pivot) will not come."

Christine Lagarde, President of the European Central Bank (ECB)
[Image source=Reuters Yonhap News]

Kuroda Haruhiko, Governor of the Bank of Japan (BOJ)
Photo by Yonhap News

◇ Major Countries Also Adjusting Pace in Line with Fed

Other countries are also approaching their interest rate inflection points. It is expected that most countries will slow the pace of rate hikes and conclude tightening in line with the Fed. However, detailed tightening paths are expected to vary slightly depending on the level of inflation control.

In Europe, which is directly affected by the Ukraine war, inflationary pressures are greater, so tightening is expected to continue at least through the first half of the year. Jorg Kramer, Chief Economist at Germany’s Commerzbank, evaluated, "Europe’s rate level (2.5%) is too low, so unlike the U.S., there is no room to cut policy rates in 2023." Currently, the market expects the European Central Bank (ECB) terminal rate to be 3.75%. The dominant view is that rate hikes will stop at this level, but cuts will not occur.

The Bank of Japan (BOJ) last month expanded the fluctuation range of government bond yields, which is being seen as a signal of a shift in monetary policy stance. Since BOJ Governor Haruhiko Kuroda, who has led quantitative easing policies, will retire in April this year, a full policy shift is expected with the appointment of a new governor. Meanwhile, the People’s Bank of China is expected to maintain an accommodative monetary policy this year to support economic recovery.