Fed minutes hint that rate hikes may still be data driven

17 Feb 2022 , 10:02 AM

When the Federal Open Market Committee (FOMC), meet on 25th and 26th January, the message was already crystal clear. Rate hikes would start as early as March 2022, once the bond buying was reduced to zero. The minutes of the FOMC meeting clearly indicate that the Fed is all set to commence its rate hikes in the Mar-22 meeting.

The minutes of the Jan-22 FOMC meet indicate that the US Federal Reserve was readying for a fight against the highest inflation and the fastest rate of price increases since the 1980s. However, Fed officials have indicated that they still expected inflation to ease through 2022, but would stand ready to hike rates rapidly if inflation did not taper. The bond buying will be wound down to zero by Mar-22, as scheduled.

Details	Oct-21	Nov-21	Dec-21	Jan-22	Feb-22	Mar-22
Bond Buying	$120 billion	$105 billion	$90 billion	$60 billion	$30 billion	-Nil-

However, the Fed has also added a caveat here that any rate hikes after March would be on a meeting-by-meeting basis based on how the macros evolve. What the minutes reveal is that even in the midst of the extreme hawkishness expectations and 40-year high inflation, the Fed still wants to keep a window to wriggle, should there be a sharp turn in the macros. Let us first take a look at what CME Fedwatch indicates on rates trajectory.

CME Fedwatch shows more certainty of early rate hikes

One indicator of the probability of rate hike and its timing is CME Fedwatch. Here are the implied probabilities of different Fed rate scenarios over the next 12 Fed meetings.

Fed Meet	25-50	50-75	75-100	100-125	125-150	150-175	175-200	200-225	225-250	250-275	275-300
Mar-22	59.5%	40.5%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
May-22	Nil	49.9%	43.6%	6.6%	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Jun-22	Nil	Nil	41.0%	44.7%	13.2%	1.2%	Nil	Nil	Nil	Nil	Nil
Jul-22	Nil	Nil	9.2%	41.8%	37.6%	10.5%	0.9%	Nil	Nil	Nil	Nil
Sep-22	Nil	Nil	2.6%	18.3%	40.6%	30.0%	7.8%	0.7%	Nil	Nil	Nil
Nov-22	Nil	Nil	1.4%	11.0%	30.2%	34.9%	18.1%	4.0%	0.3%	Nil	Nil
Dec-22	Nil	Nil	0.4%	4.3%	16.9%	31.7%	29.8%	13.8%	2.8%	0.2%	Nil
Feb-23	Nil	Nil	0.3%	3.0%	12.6%	26.7%	30.5%	19.2%	6.5%	1.2%	Nil
Mar-23	Nil	Nil	0.1%	1.3%	6.8%	18.1%	28.2%	26.1%	14.3%	4.4%	0.7%
May-23	Nil	Nil	0.1%	1.0%	5.3%	15.1%	25.5%	26.7%	17.4%	7.0%	1.9%
Jun-23	Nil	Nil	NIL	0.6%	3.5%	11.0%	21.2%	26.2%	21.3%	11.3%	4.8%
Jul-23	Nil	Nil	NIL	0.5%	3.0%	9.6%	19.3%	25.3%	22.2%	13.2%	6.9%

Data source: CME Fedwatch

Normally a probability in the range of 25% to 30% is a strong indication of affirmative action.

• It is now almost certain there will be the first rate hike in Mar-22, and the bond futures markets are pencilling in a very strong possibility of a 50 bps rate hike to begin with.
• By June 2022, the bond futures are building in a strong likelihood of rates rising by 100 bps to the range of 1.00% to 1.25%.
• By December 2022, the Fed futures probabilities are making the case for a total of 150-175 bps rate hike, hinting at probabilities moving higher since the Jan-22 FOMC meet.
• For now, the markets are expecting the Fed rates to stabilize around their long term target of 200-225 bps by Feb 2023, which matches with Goldman’s estimate of 175-200 bps rate hike over next one year.

While the Fed minutes have tried to occasionally play devil’s advocate, the futures market appears to be quite hawkish about rates in the light of the recent spike in inflation.

Key takeaways from the FOMC Minutes (Jan-22 Fed Meet)

If the FOMC meeting was an acknowledgement of the need to hike rates, the minutes indicate that the rate hikes are coming. However, the Fed has added a caveat that actual decision points beyond March 2022 would be data driven. Here are key takeaways.

a) Fed has acknowledged that it was time to hike rates starting March 2022. However, the Fed has tried to maintain a delicate balance indicating that it would not want to provide any trajectory and rather stick to a data driven approach to rate action, beyond March.

b) Fed expects inflation to ease through 2022 but is ready with a Plan-B of aggressive tightening if the inflation rates were to spike very sharply. Currently, inflation for Jan-22 at 7.5% is the highest level seen since 1982.

c) The general consensus among FOMC members was that if inflation did not taper as expected by the Fed, then the Fed should combine rate hardening along with liquidity tightening by way of a drawdown on the $9 trillion Fed bond book.

d) The FOMC member consensus, for the time being, is that the rapid pace of inflation will warrant raising rates more than once a quarter. This could be a pointer to rate hikes in each of the 7 FOMC meetings remaining in year 2022.

e) The minutes and the CME Fedwatch indicate that the rate hike would be front-ended to 50 bps in March 2022 due to the huge negative gap between the Fed rate and the rate of inflation; already the deepest negative real rate in the developed world.

f) However, if you look at bond yields of the 10-year benchmark; it has tapered from a high of 1.92% to around 1.52% underlying the market assessment that given a choice the Fed would still want to be assured that the economic momentum was not impacted.

g) To sum it up, the minutes only disclose that there is a rate hike coming in March 2022, so going ahead the stickiness of inflation will hold the key to future rate action. If inflation tapers in response, then there may be a positive surprise for bond markets.

h) Finally, on the subject of the $9 trillion bond book unwinding, there is not much clarity. More guidance is expected on this subject in the Mar-22 policy. However, Fed may still keep that as a back-up strategy.

What are the takeaways for India from the Fed minutes?

There are 3 key takeaways for India from the Fed minutes announced on 16th February.

• Indian bond markets and the central bank must be prepared for a 50 bps rate hike in March. Like in the past, the first rate hike is likely to induce volatility in Indian bond, equity and forex markets and that could be the immediate concern.
• The bigger challenge will be handling the IPO flows, especially considering that the LIC IPO is expected around the time of the Mar-22 Fed meet. That could induce a lot of caution among the institutional investors globally.
• The minutes put a greater onus on the RBI to chart out a trajectory on rates and liquidity ahead of its April 2022 policy. The Fed minutes have almost made it inevitable for the RBI to seriously look at a rate hike in its April policy, or even before that.