Fed halts rate hikes after 15 months, but keeps outlook hawkish

15 Jun 2023 , 10:28 AM

It was on the cards and the Fed finally decided to bite the bullet. After a gap of 15 months, the Fed finally called a halt to its rate hikes. Since March 2022, the US Federal Reserve has hiked rates 10 times taking the rate of interest from the range of 0.00%-0.25% to the current range of 5.00%-5.25%. That is a full 500 bps hike in a span of 15 months. In the minutes of the May 2023 Fed policy, the members appeared clearly divided over continuation of rate hikes at the same pace. The general consensus was that the Fed should pause in June and let the lag effect of rate hikes play out on inflation. That is what Fed did!

There are two things to know about this Fed rate pause in June 2023. Firstly, this pause is not just an outcome of the evolving banking crisis in the US and tighter consumer credit, but also consistently falling inflation. In the latest May reading, the consumer inflation was down by another 90 bps to 4.0%. On the other hand, the Fed statement also underlines the possibility of another 2 rate hikes in this calendar year. After all, at 4%, the inflation is still double the Fed target of 2% and the job market continues to look undersupplied.

Neutral for now, but hawkish for 2023

One way to look at the Fed outlook from a market perspective is the CME Fedwatch, which captures probabilities of rate levels after each Fed meet over next 1 year.

Fed Meet	325-350	350-375	375-400	400-425	425-450	450- 475	475-500	500- 525	525-550	550-575
Jul-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	30.6%	69.4%	Nil
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	25.7%	63.2%	11.1%
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	2.2%	28.9%	58.8%	10.2%
Dec-23	Nil	Nil	Nil	Nil	Nil	0.5%	8.1%	35.5%	48.1%	7.9%
Jan-24	Nil	Nil	Nil	Nil	0.2%	3.9%	20.5%	41.2%	29.8%	4.3%
Mar-24	Nil	Nil	Nil	0.1%	2.6%	14.4%	33.5%	34.0%	13.8%	1.6%
May-24	Nil	Nil	0.1%	2.5%	14.2%	33.3%	34.0%	14.1%	1.8%	Nil
Jun-24	Nil	0.1%	1.7%	10.0%	26.3%	33.7%	21.3%	6.2%	0.7%	Nil
Jul-24	0.1%	1.4%	8.9%	24.2%	32.8%	23.0%	8.2%	1.4%	0.1%	Nil

Data source: CME Fedwatch

While the Fed statement gives the regulatory and policy perspective, the CME Fedwatch gives a market perspective. Just about 3-4 months back, the market view had strongly diverged from the Fed. Even as the Fed had been insisting on no rate cuts in 2023, the markets had gone ahead and factored 100 bps rate cut in 2023 and up to 200 bps rate cut by mid-2024. A lot has changed in the last 3 months on market perception of rates.

For one, the markets have realized that the Fed is likely to steadfastly stick to its stand. The Federal Reserve takes its communication very seriously and normally sticks to its word. The markets have now almost entirely shifted to the Fed view on rates. The differences are now very minor. For instance, the Fed statement has clearly hinted at another 50 bps rate hike in 2023. However, the CME Fedwatch is only factoring in 25 bps rate hike with an outside possibility of 50 bps rate hike. On the rate cuts, the markets are actually more conservative. While the Fed hinted at up to 100 bps rate cut in 2024, the market is factoring in just about 75 bps. The moral of the story is that the CME Fedwatch, in the last 3 months, is increasingly veering towards the Fed view.

What we read from the June 2023 Fed statement

The pause in rates in June was along expected lines as the Fed members felt it was prudent to let the lag effect of rate hikes manifest itself. The Fed finally called a pause after 15 months and 10 consecutive rate hikes. Here are key takeaways from the Fed statement.

• Even as the Fed paused on rate hikes, it has cautioned the markets that further rate hikes were on the anvil. The Fed dot plot has hinted at another 50 bps rate hike in 2023 in two tranches of 25 bps each. However, the Federal Open Markets Committee (FOMC) unanimously voted to skip rate hikes in the June meeting.

   

• There were several justifications for this pause. Firstly, the Fed wanted to allow the trickle down effect of rate hikes to be factored in fully. Secondly, the inflation reading for May 2023 came in sharply lower at 4%. Thirdly, the banking crisis had already tightened consumer credit, doing part of the job that rate hikes are supposed to do.

   

• The Fed statement is also very clear that additional rate hikes are still necessary to cool down the inflation further from 4% to the target rate of 2%. The pause in June will give more time for the Fed to observe the lag effect of 15 months of hawkishness. Fed dot plot is hinting at 50 bps rate hike in 2023 and a 100 bps rate cut in calendar 2024.

   

• The rate cuts in 2024 are based on the premise that the Fed would start turning around the interest rate cycle as the consumer inflation approaches the 2% mark. The Fed wants to be doubly sure that it does not become late in reversing the interest rate cycle, which is already well above the neutral rate zone. This risks an impact on GDP growth.

   

• One of the key parameters for the Fed has been the unemployment rate. In the latest reading; up from 3.4% to 3.7% due to tightness in the job market. The Fed expects the unemployment rate to spike to 4.1% by end of 2023, which would be in sync with the lower inflation target of 2%.

   

• There is a subtle shift in the Fed policy from pure headline inflation. With consumer inflation down to 4% and moving towards 2%, the Fed is shifting its focus largely to the unemployment data and the core inflation data. Even in the March reading, the core inflation in the US remains elevated at 5.3%, well above the headline inflation rate.

   

• What makes the Fed confident of moving to 2% inflation. According to Powell, shelter costs make up 40% of the CPI basket and that has been trending lower. Also, the tightening credit conditions, with consumer credit much harder to come by, should play a catalytic role in reining in inflation rapidly in the coming months.

   

• For the first time, there has been an official indication of the terminal rate of interest in the US at 5.6%. that approximately corresponds with the repo rate range of 5.50%-5.75%, implying another 50 bps rate hike from current levels. The all-important PCE inflation in the US is also likely to drift towards 2% by 2024.

   

• Fed rates are already at the highest level since 2007,when it stood at 5.25%. Of course, the global financial crisis had then forced the Fed to take rates right down to zero levels. For now, the central banks like the Bank of England and the ECB are still hawkish and the question is whether the Fed would risk divergence should other banks turn neutral?

The Fed has announced a pause in rate hikes, but has also hinted that rate hikes have another 50 bps to go. This time around, the market expectations are also in sync.

What does the Fed statement mean for the RBI?

The RBI had announced a pause in rates in April 2023, at a time when the Fed had still remained hawkish. In the Indian context, the lag effect theory appears to have worked. In April, the RBI decision did look like a big risk as it could have resulted in monetary divergence. In retrospect, the decision not only placated the industry bodies, but also allowed the cumulative effect of the rate hikes over the last one year to play out.

For the RBI, the comfort level is that the inflation target is now just about 25 bps away, while the Fed still has to traverse another 200 bps to get to its target of 2% inflation. However, the RBI would breathe easier as the US pausing on rates makes the risk of monetary divergence a lot lesser. It also promises less volatility in portfolios flows and in global currencies. That is something the RBI and the Indian economy can savour for now.