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Fed minutes hint at slower rate hikes but steeper peak rates

If one were to read the minutes of the November FOMC meet announced late on 23rd November, there are two themes that come out sharply.

November 24, 2022 10:12 IST | India Infoline News Service
Firstly, the pace of the rate hikes is likely to slow in the coming months. That was obvious after 4 consecutive rate hikes of 75 basis points each. The second message is that the terminal rate will be higher than originally envisaged, but now it is emerging that the median rate could be between 5.25% and 5.50%.

In the last 4 meetings, the Fed has raised rates by 75 bps each. Apart from the 300 points, it had raised rate by 75 bps in 2 tranches before that, taking the total rate hike to 375 bps till date. However, as the Fed had originally planned, most of the rate hikes are likely to be front-loaded in 2022, with 50 bps rate hike likely in the December 2022 FOMC meet.

With the third quarter GDP turning around to positive in the US and consumer inflation now tapering faster, the Fed has reasons to stay hawkish for some more time. Despite being well above the neutral rates of 2.50%, the Fed may have to hike rates by another 100 to 125 bps before a clear impact is visible on the level of inflation. That is what Fed is preparing to do.

CME Fedwatch gives positive hints after minutes

The Fed may continue to adopt a hawkish tone but the Fedwatch probabilities below indicate that the bias is shifting lower. Now, the peak rate expectations are that it will not exceed 5.5%, although that is still 150 bps away. Here are the implied Fed rate scenarios over next 9 meetings.

Fed Meet 400-425 425-450 450-475 475-500 500-525 525-550 550-575 575-600 600-625
Dec-22 Nil 75.8% 24.2% Nil Nil Nil Nil Nil Nil
Feb-23 Nil Nil 35.2% 51.9% 13.0% Nil Nil Nil Nil
Mar-23 Nil Nil 10.8% 40.3% 40.0% 9.0% Nil Nil Nil
May-23 Nil Nil 6.4% 28.2% 40.1% 21.7% 3.7% Nil Nil
Jun-23 Nil 0.7% 8.7% 29.4% 38.2% 19.8% 3.3% Nil Nil
Jul-23 Nil 1.3% 10.2% 30.1% 36.8% 18.6% 3.0% Nil Nil
Sep-23 0.4% 3.8% 15.8% 32.0% 31.7% 14.2% 2.2% Nil Nil
Nov-23 2.3% 9.9% 24.0% 31.8% 22.8% 8.1% 1.1% Nil Nil
Dec-23 8.9% 19.4% 29.3% 25.8% 12.9% 3.4% 0.4% Nil Nil
Data source: CME Fedwatch

Here are some quick takeaways from the CME Fedwatch probabilities in the aftermath of the FOMC minutes announcement. These probabilities are dynamic but normally give the best indication after a key event.
  • With 300 bps rate hike done in the last 4 meetings, the Fedwatch is hinting at another 50 bps rate hike in December and a few more smaller rate hikes in 2023. The consensus emerging is that the peak rates would be in the range of 5.25% to 5.50%.
  • The peak rate, as per the Dot Plot Chart would be a full 300 bps above the neutral rate, so the impact on inflation should start gathering momentum from here on. The tightness is already visible in different data points in the US economy.
  • While a 50 bps rate hike in December and a few 25 bps rate hike after that look the likely road ahead, a lot would still depend on how the consumer inflation pans out. The bet is on the inflation falling rapidly over the next 5-6 months.
  • While the peak rate is indicated at 5.25% to 5.50%, there is another interesting trend that emerges from the data. The market sees a strong possibility that if the inflation reacts fast, then rates may even be cut in the second half of 2023.
One thing is clear that the Fed is not relenting on its inflation battle. The pace is likely to slacken, but that is more due to the Law of large numbers, as the base has gone up.

What we read from the November 2022 Fed minutes

The consensus that emerges from the Fed minutes is that the pace of rate hikes will slacken with more clarity emerging on the peak rate of interest. However, the Fed minutes highlighted a number of other key points too. Here is what we read from the minutes.
  1. Going ahead, Fed officials would like to keep the rate hikes smaller so as to evaluate the impact that the policy is having on the economy; both in terms of inflation and in terms of growth. They want to give time to the economy to adapt to the rapid changes.
  2. However, like in the previous meetings, the Fed did not see inflation abating too rapidly with the first signs of tapering of inflation likely to be visible in 2023 only. However, Fed has hinted that it may start reversing rate hikes or halt rate hikes once there is clear and indisputable evidence of inflation tapering. Fed will not wait till 2% inflation.
  3. To justify a slower pace, the members of the FOMC have cited the uncertain lags and magnitudes associated with monetary policy actions on economic activity and inflation. They have basically asked for more time to assess the impact. Some members of the FOMC have also suggested that slowing the pace of rate hikes would reduce the risk of instability to the financial system.
  4. Fed members have now tried to shift the focus from the pace of rate hikes to the terminal rates (end rates). Fed feels it has to continue rate hikes well into next year, with the consensus terminal rates now emerging in the range of 5.25% to 5.50% in a worst case scenario. That would still leave about 3-4 rate hikes in 2023.
  5. There was an interesting sentence in the minutes which read, “In determining the pace of future increases in target range, the FOMC will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments“. That is a clear indication that going ahead, Fed would not be obsessed with inflation alone.
  6. However, what we can gather from the Fed minutes is that there is still no clarity on when the rate hikes would end, although the street consensus appears to be middle of 2023. For now, the only clarity available is that there would be a 50 bps rate hike in December 2022 and a few more rate hikes of 25 bps after that.
  7. The FOMC has specifically noted that the inflation data had been lately showing encouraging signs even while remaining well above the central bank’s 2% official target. In October, consumer inflation had fallen to 7.7% with a fall in inflation levels across food inflation, core inflation and fuel inflation sub-segments.
  8. The reaction of the Dow and the NASDAQ to the minutes was positive. While the market remains worried about too much of tightening, the markets are also suggesting that the Fed should reduce its accent on backward-looking data and instead focus on high frequency signals that inflation is ebbing or growth is slowing.
The present dilemma of the Fed and the uncertainty of the markets was best summed up by the Fed Chair Jerome Powell. “There is risk in both directions; in doing too little and also in doing too much”. He is bang on target. Big risks call for big counter actions. That is what the Fed is doing. Hopefully, the results should be more positive by early 2023.

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