Fed starts down a path of aggressive hikes

The Federal Reserve hiked rates by 75bps at the June FOMC meeting, bringing the Fed funds rate to 1.75% on the top end. The statement from the meeting showed that the FOMC is “strongly committed to returning inflation” to the Fed’s target level of 2% and will be prepared to “adjust the stance of monetary policy as appropriate” if conditions push back against reaching the inflation target level. There was one dissent at the June FOMC, with Kansas City Fed president Esther George voting in favour of a 50bps hike. In the post-meeting press conference, Chair Powell indicated that it was the higher than expected May inflation reading as well as an increase in inflation expectations in some recent surveys that led the FOMC to hike by more than they had indicated in prior guidance.

The Fed also released its updated summary of economic projections. Real GDP growth was downgraded to 1.7% this year from 2.8% at the March FOMC while the unemployment forecast for 2022 was revised up slightly to 3.7% from 3.5% previously. There was a larger revision to the 2023 unemployment forecast with the Fed now seeing 3.9% next year compared with 3.5% previously. The rise in unemployment while the economy continues to grow at 1.7% looks to be a particularly challenging outcome to achieve. As expected, the Fed also revised its inflation projections higher, seeing the PCE deflator at 5.2% in 2022 compared with 4.3% previously but is still expecting a considerable slowdown into next year of 2.6%.

The FOMC now expects the Fed Funds rate to rise to 3.4% this year and 3.8% in 2023 compared with 1.9% and 2.8% previously. The range of expectations for the Fed funds rate is narrower for 2022 while for 2023 it ranges from 2.9% on the low end to as high as 4.4% on the top end. However, the Fed does outline that rates will start to come down by 2024 with the median projection for the Fed funds rate at 3.4% two years out.

Brief relief

Markets seemed to take solace in Fed chair Jerome Powell’s commentary that the next move could be 75bps or 50bps with futures and options markets currently splitting the difference for where rates will be at the July meeting. Equity markets and bonds rallied while the dollar sold off in the immediate response to the FOMC and press conference. Given that inflation is unlikely to materially improve by the Fed’s measures by the July meeting, we don’t see what would change the Fed’s calculus to allow them to use a 50bps hike given they did 75bps at this meeting.

The June FOMC and press conference were also notable for not making any direct commentary on changes to the quantitative tightening the Fed is currently running. Accelerating the pace of balance sheet run down could have a material effect on pushing up longer-term yields, and household and borrowing costs, and thus make decisions on purchasing and investment more cautious. A material change in how households have to break down their budgets on housing costs versus marginal expenses should help to cool some of the excess demand that Chair Powell was at pains to stress is an issue for the economy.

What’s next?

Where does the Fed go from here? For the past year it has been following—or chasing—the market higher in terms of rate expectations and indeed a new median rate projection of 3.4% for the end of this year gets them to where the market was following the hot May CPI print. A 75bps hike at the July meeting now looks likely given they used that size of a hike for June. The Fed’s inflation targets to us still appear to be too low as they would imply a steady and sizeable deceleration in inflation essentially  every month from hereon to the end of the year. External inflation drivers, which chair Powell said the Fed has little influence over, are going to continue to run at an elevated pace. We then expect the Fed will need to hike consistently this year in order to achieve its aim of seeing a sustained decline in inflation prints and after a 75bps hike in July will use 50bps hikes from the September meeting on, bringing the Fed funds rate to 4% by the end of this year. For 2023, the risks of a sharp economic slowdown if not outright recession look acute and we are still penciling in two smaller 25bps hikes for H1 2023 before the Fed either holds or starts to provide more accommodative policy in the face of much weaker economic conditions.

Source: Bloomberg, Emirates NBD Research