Federal Reserve pushes back against inflation

The Federal Reserve raised policy rates by 50bps at the May FOMC, taking the Fed funds target rate to 1% on the upper bound. The Fed also gave notice that it would start to run down its balance sheet from June 1st at an initial monthly pace of USD 47.5bn before ramping up quickly to USD 95bn per month after three months. The Fed indicated it was “highly attentive to inflation risks” that are currently affecting the US economy while also affirming that the US economy for now remains in good shape.

The FOMC statement gave the Fed some flexibility to raise rates at a more aggressive pace, noting that it would be “prepared to adjust the stance of monetary policy as appropriate if risks emerge” though in his press conference after the statement Fed chair Jerome Powell pushed back on the need to use 75bps hikes, instead lining the market up for two addition 50bps hikes at the June and July FOMC meetings. The vote in favour of the 50bps hike was unanimous.

Markets have now positioned for 50bps hikes at least at the next two FOMC meetings before 25bps hikes over the rest of the year. That would bring the Fed funds rate to 2.75% at the end of 2022. Our pre-meeting expectation was for 50bps at the May and June FOMC meetings and then 25bps at the subsequent sessions to an end-year rate of 2.5%. We noted that risks to the outlook were on the upside given the Fed’s focus on fighting back against inflation and we are now adjusting our outlook upward by a further 25bps to an end-year level of 2.75%.

So far the US economy isn’t showing signs of a material slowdown even as high prices and a higher rate outlook bites. The labour market remains in robust health and the April non-farm payrolls numbers due at the end of this week are expected to show additional gains of 380k jobs while services sector activity still remains strong: the April ISM services PMI was at 57.1 while retail sales an industrial production are coming in not far off expected levels.

In the second half of the year, however, the full impact of tighter policy will start to be felt and will likely be contributing to softer employment conditions and weaker business activity. Inflation is likely to come down in H2 2022, abetted by base effects and also by a dip in domestic demand in the US. But many of the inflationary drivers will still be caused by exogenous variables related to the war in Ukraine disrupting energy and agricultural flows and still gummed up supply chains. Thus while we expect for now 25bps hikes at the meetings after the July FOMC they may be relatively more ‘data dependent’ than the two 50bps hikes in June and July.

For 2023 we still have two 25bps pencilled in for H1 but if the US economy is showing material signs of slowdown then the Fed may be willing to decelerate its path of policy normalization to avoid pushing the US into a substantial recession.