Fed hikes rates by 75 bps in July in big inflation fight

28 Jul 2022 , 09:05 AM

The Fed had skilfully built expectations of a likely 100 bps rate hike, so when the Fed actually hiked rates by 75 bps on 27th July, it almost appeared like manna from heaven. So much for managing expectations!

Chart Source: Bloomberg

However, that does not conceal the extent of hawkishness in the words of the Fed, nor does it take away the potent risk that the US economy could slip into a full-fledged recession. Jerome Power, in his statement, rejected talks of US recession. But, recession is not about perspectives but about data, and data is showing 2 consecutive quarters of weakness.

What would really worry markets is that the Federal Open Market Committee (FOMC), including the redoubtable Jerome Powell, appeared unperturbed by recession fears. Powell has confirmed that another similar hike in September was not ruled out, if inflation stayed sticky. Remember, Fed has hiked rates by 225 bps since March and 150 bps in last 2 months.

Peak rate expectations now converging to 3.75%

Here is a quick look at the CME Fedwatch implied probabilities. Rates have already risen from the range of 0.00%-0.25% to the range of 2.25%-2.50% between March 2022 and July 2022. Here are the implied Fed rate scenarios over next 8 meetings.

Fed Meet	275-300	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525
Sep-22	65.0%	35.0%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Nov-22	Nil	53.4%	40.4%	6.2%	Nil	Nil	Nil	Nil	Nil	Nil
Dec-22	Nil	33.0%	45.3%	19.3%	2.4%	Nil	Nil	Nil	Nil	Nil
Feb-23	Nil	25.7%	42.6%	25.0%	6.1%	0.5%	Nil	Nil	Nil	Nil
Mar-23	10.8%	32.8%	35.2%	17.1%	3.8%	0.3%	Nil	Nil	Nil	Nil
May-23	Nil	10.8%	32.8%	35.2%	17.1%	3.8%	0.3%	Nil	Nil	Nil
Jun-23	10.8%	32.8%	35.2%	17.1%	3.8%	0.3%	Nil	Nil	Nil	Nil
Jul-23	10.0	31.2%	35.0%	18.4%	4.7%	0.6%	Nil	Nil	Nil	Nil

Data source: CME Fedwatch

Apart from the regular hawkishness, some interesting trends emerge.

·         With a record 150 bps rate hike in June and July, the Fedwatch is hinting at around 100 bps of rate hike more by the end of December 2022.

·         That means, with rates already in the range of 2.25%-2.50%, the markets are betting on more gradual rate hikes of around 100 bps over the next 3 meetings till the end of 2022.

·         As of July 2022, the Fed rates are already at neutral levels. Any hike beyond these levels would start to directly hit the economic growth, despite negative real yields.

·         It now looks like the Fed will not just front-load rates in 2022, but perhaps complete 90% of the rate hikes in 2022 itself. That gives room for corrective action, if needed, in 2023.

·         Powell has confirmed that the asset unwinding program was on schedule, so that would amplify the impact of rate hikes on growth and liquidity in the markets.

The gist of the FOMC statement for July 2022 was that rate hikes would be relentless till inflation came down to 2%. Of course, the unsaid portion was that all these would be circumscribed by the pragmatic considerations of economic growth.

What we gathered from the July 2022 FOMC statement

Here are some of the key takeaways that emerge from the FOMC statement and the subsequent elaboration issued by Jerome Powell, Chairman of the Federal Reserve.

a)      While hiking the rates by another 75 bps in July, Powell has underlined that a similar move was possible again, despite the fact that the Fed has hiked rates by 225 bps since March 2022 and by 150 basis points between June and July 2022

b)      Just to give a perspective, record inflation called for unprecedented hawkishness by the Fed. The hike of 150 bps in the Fed rate over just 2 months is the steepest rate hike since the aggressive anti-inflation era of Paul Volcker in early 1980s.

c)      The first signal of pragmatism comes from Powell’s admission that, going ahead, the Fed would be more data driven. That is understandable since between now and the next statement on 21st September, there will be 2 inflation and employment readings. Rate decisions would be taken more on a meeting by meeting basis.

d)      However, Citigroup has cautioned clients in a note that inflation in the US was unlikely to relent quickly and growth triggers may remain ambivalent. Hence, another 75 bps rate hike could not be ruled out in the forthcoming September 2022 meeting. The consensus is veering towards a 50 bps rate hike in September.

e)      At the current range of 2.25%-2.50%, the Fed rates are already at neutral levels ( a level that neither speeds nor slows down the economy). However, from this point, every rate hike would be taking the rates above the neutral rate with direct negative implications for growth. Inflation may eventually come down, but at the cost of weak GDP growth.

f)       On the subject of the US economy slowing, Fed is relying more on the strength in the labour market rather than worrying about the weak GDP growth indicated by the GDPNow estimates of the Atlanta Fed. That makes the Fed less likely to pause on rate hikes, at least till the end of 2022.

g)      The Fed reiterated its commitment to being “highly attentive to inflation risk”. That means, it would not relent on rate hikes till the time inflation gravitated closer to the 2% mark. That could come at the cost of economic growth, but that is a separate debate. However, Fed has committed to adjust the trajectory should risks to growth emerge.

h)      Even though labour data is still strong, high rates are already impacting appetite in the housing market where sales have slowed. In addition, Q1 has seen GDP contraction and Q2 is likely to be flat at best. Yield curve dipped into negative for the third time.

i)        Soft landing continues to be a debatable issue. While the Fed is confident that higher inflation would constrain spending and contain inflation, the market is sceptical and believes that it will take recession with mounting unemployment to slow inflation.

To sum up the Fed stance, they are looking at a period of growth below potential to create some slack, so supply side can catch up. While markets focus on GDP growth, the Fed is still focussed on strong labour markets. But what does this really mean for the Indian economy?

India must worry about too much hawkishness

In recent days, even the ECB has joined the hawkish club by hiking rates by 50 bps, something unheard of. India has already hiked rates by 90 bps and CRR by 50 bps. Till now, India is in neutral territory. But, going ahead, another 100-125 bps of rate hike by the Fed could create a real poser for the Indian policy makers.

IMF has already projected subdued growth for India and the world in 2023 and 2024. A slowdown in the US and China would impact India’s trade substantially as they are two of India’s largest trading partners. India has lived with FPI outflows for over 9 months without too much of a dent on the markets. The tougher job will be in the next 4 months!