One thing that could have given the confidence to the Federal Open Markets Committee (FOMC) for this hawkish stance is the strong labour data as well as the robust GDP numbers in the third and fourth quarter. US GDP grew 3.2% in the third quarter and the advance estimates hint at 2.9% growth in the third quarter. The final data will be out on 23rd February.

If one looks at the dot plot chart pencilled by the FOMC members, there are 3 things that come out explicitly. Firstly, in last few weeks, there has been a shift towards more hawkish expectations. We will see that in greater detail when we review CME Fedwatch data. Secondly, Fed members believe that gradual rate hikes may not work as they get absorbed too easily. The answer lies in front-ending and higher terminal rates. Lastly, Fed members believe, growth triggers and labour data is strong enough to justify longer hawkishness.

What the CME Fedwatch data tells us

CME Fedwatch reflects implied probabilities of future rate hikes based on Fed futures pricing. It is market based pricing of hawkishness risk. The table below captures probabilities of different rate levels after the remaining 7 Fed meets in year 2023.

Data source: CME Fedwatch

Since November, Fed had turned less hawkish, but that appears to be changing in February. With the rate hikes slowing, it looks like it may take much longer than the end of 2023 to put the US economy on path to 2% inflation. Obviously, the FOMC members have turned distinctly hawkish in February. Here are some key takeaways from the CME Fedwatch data.

• There has been a clear rightward shift in the data. Now, markets are targeting Fed rates in the range of 5.50% to 5.75% by July 2023. The peak rate assumptions also moved closer to the range of 5.75% to 6.00%.
  
   
• Till early February, there were strong expectations of a rate cut in the second half of 2023. Now it looks very likely that rate cuts may happen in 2024, instead of 2023. There is just an outside probability of rate cuts in 2023.
  
   
• With Fed rates currently in the range of 4.50% to 4.75%, the markets are pencilling in additional rate hikes of 75-100 bps in a likely scenario and 100-125 bps in a worst case scenario. Which means; rates could scale closer to 6%, or even beyond.
  
   
• It is back to front-ending with a strong probability that the March Fed meet may see a rate hike of 50 basis points instead of 25 bps. This is likely to be followed by another 2 or 3 round of 25 bps each.

Fedwatch is clearly factoring in higher terminal rates and also more front ending of rate hikes in the first half of 2023; in a clear market vote for hawkishness.

What we read from the February 2023 FOMC minutes

Broadly, members of the FOMC are still committed to bringing down the pace of rate hikes. However, February FOMC minutes betray a sense of urgency in front-ending rate hikes. All members of the FOMC have hinted at “curbing unacceptably high inflation” as a key monetary policy mission. Here is what we read from the FOMC minutes for February 2023.

1. The gist of the policy minutes was that Fed rates will have to move higher and rate hikes may once again be front-ended. Going ahead, the intent of the Fed would be to limit the rate hikes from this point, although there is no clarity on the terminal rates. From the data available, the terminal rates appear to gravitate towards 6%.
   
    
2. The members of the FOMC have specially taken note of the upside risks to the inflation outlook, considering the risks to the food basket and the fuel basket. US has seen core inflation coming down progressively, although it still remains well above 5%. FOMC members concurred that the focus on path to 2% will not be compromised. 
   
    
3. Despite inflation touching 40-year highs and down just marginally, there was only a minority in favour of front ending of rates. However, the Fed may veer towards a front-ending of 50 bps rate hike in the March meeting to ensure that short term consumption driven inflation pressures are kept at bay.
   
    
4. In the February meeting of the Fed, the terminal rate of inflation based on the dot plot chart had moved up from 5.1% to 5.6%. Now even that does not look too realistic. It appears that the March 2023 Fed policy could see the terminal Fed rates moving decisively towards 6% or marginally above that.
   
    
5. That brings us to the recession risk in the US economy. To avoid too much speculation on recession, FOMC avoided specific talk on terminal rates. But the markets have manifested this risk in spike in bond yields. Recession remained a concern with members pointing to sharp fall in consumer spending since 2022. However, savings and budget surpluses were offsetting forces.
   
    
6. One of the factors standing between rate hikes and inflation control appears to be strong labour data. The US economy is adding jobs at a record pace and that is buffering most of the rate hike impact. The result is that inflation is 2.5 times the target for January and that can be largely attributed to robust jobs data.
   
    
7. More than the data, it is often the perception or the assumptions that matter. The minutes reveal that Fed officials are still attuned to the risk they may have to do a lot more to keep inflation falling. The Committee feels that giving up on hawkishness at this point would not only compromise the fight against inflation, but also raise inflation expectations among consumers.

Clearly, hawkishness of the Fed is not going away in a hurry, and that appears to be the singular message from the Fed minutes.

What do the Fed minutes mean for India?

Interestingly, the Fed minutes came on the same day that the MPC minutes were announced by the RBI and the undertone was also the same. Both the RBI and the Fed are unwilling to give up on hawkishness. Here are 3 key takeaways for India.

• It looks like hawkishness is here to say, at least, till inflation shows a decisive move downward. In India, the impact is visible in WPI inflation but not in CPI inflation.
  
   
• Indian corporate balance sheets are more vulnerable to funding costs as we saw in Q3FY23. More hawkishness would only mean more pressure on operating margins.
  
   
• The good thing is that the RBI MPC is now getting increasingly divided in its opinion. Rates is what the government and RBI can control and that is what they must do. The focus must be to ensure that the cost of funds do not got out of hand, to the detriment of corporate profit margins.

The impact on Indian markets is visible. Too much hawkishness has not gone down well. It is now over to the fiscal hints from the government to offset this hawkish narrative.

The Federal Reserve Act requires the Federal Reserve Board to submit the Monetary Policy Report semi-annually to the Senate Committee on Banking and to the House Committee on Financial Services. Typically, each year, this report gets submitted towards the end of February and then again towards the end of June. 

This Monetary Policy report submitted to the Congress makes the Federal Reserve Board accountable for its commitments and for the outcome of their actions. The Fed finds itself in a piquant situation at this point. For example, the inflation triggers are favourable in the sense that oil and commodity prices are falling and even food prices have tapered from the highs. However, the fall in inflation has not been as rapid as expected, and that is largely due to sticky core inflation. In addition, tight labour market is also making transmission of higher rates into lower inflation difficult. That is because, higher wages among the consuming population are offsetting the higher cost of funds brought about by Fed hawkishness. This is the background in which the report was submitted by FRB.

Monetary policy report broadly covers 3 areas viz. (1) progress on interest rates (2) progress on reducing size of Fed balance sheet and (3) Outlook for rates and inflation in future.

Federal Fund rate hikes have continued

The hawkish monetary policy of the Fed just about completes one year in March 2023. Between March 2022 and February 2023, the Fed has increased the interest rates from the range of 0.00%-0.25% to the range of 4.50%-4.75%. This 450 bps rate hike is not only the fastest pace of rate hike in just 11 months, but also it is the highest level of Fed Funds rate since the year 2007 (just prior to the global financial crisis). Between June 2022 and November 2022, the Fed hiked rates by 75 bps on 4 occasions. However, the rate hikes were toned down to 50 bps in December 2022 and further to 25 bps in February 2023.

However, the minutes of the February 2023 FOMC (Federal Open Markets Committee) clearly indicate a shift towards a more hawkish policy. The Fed has not only indicated the likelihood of another 50 bps rate hike in the forthcoming meeting, but has also hinted at a higher terminal rate of interest veering towards the range of 5.50% to 5.75% and even going up to 6% in a worst-case scenario. Clearly, Fed thinking on the trajectory of rates appears to have undergone a shift in 2023; and we shall see more of this aspect later.

Fed reduces its holdings consistently

When the Fed started the hawkish approach in March 2022, it was clear that it would combine rate hikes with winding down the assets on the Fed balance sheet. The idea was to amplify the impact of rate hikes with liquidity tightening so that monetary policy is more effective. Between June 2022 and February 2023, there has been a perceptible shift in the Fed balance sheet as the shrinking has continued at around $60 billion per month. That may sound paltry in the light of the $9 trillion Fed balance sheet last year, but it has surely helped balance inflation and liquidity in a meaningful way.

Data Source: US Federal Reserve

First a quick background to the building of the Fed balance sheet. During the global financial crisis of 2008, the Fed and other central banks around the world embarked upon monetary easing in a big way. The easiest way was to infuse liquidity in the market by buying treasury securities and mortgage debt. However, while this did infuse liquidity, it also expanded the Fed balance sheet. Between 2008 and 2013, the Fed balance sheet had expanded from $2 billion to $4 billion. However, since 2016, the Fed had been consistently pruning its balance sheet size; till the COVID pandemic changed all that.

When the pandemic struck in late 2019 and early 2020, the Fed had to once again resort to liquidity infusion to ensure that there was sufficient liquidity in the market so that growth did not suffer. However, this surfeit of liquidity had two implications. Firstly, it once again expanded the Fed balance sheet (this time to a whopping $9 trillion). Secondly, with too much liquidity sloshing around in the economy, the inflation started to go up sharply. That is when the Fed decided to amplify the rate hikes with balance sheet unwinding to address the challenge of persistently rising inflation. As can be seen from the table above, the Fed assets have shrunk by $550 billion (6.16%) between June 2022 and February 2023.

FOMC outlook on key economic indicators

The third and last part of the Monetary Policy report submitted by the FRB to the Congress is about the projections that the Federal Reserve has made for key macroeconomic parameters. The table below captures the Fed projections of key macros for the next 3 years, and the long-term sustainable rate.

Data Source: US Federal Reserve

The above table has two data points of note. Firstly, it shows the projected values of various variables for the next 3 years and the long run sustainable rate. In addition, the high frequency trends are also evaluated since each variable is also compared with the September 2022 projection. Here are some of the key takeaways.

1. Real GDP growth is expected to stabilize at around the long-term rate of 1.8% by 2025 and sustain after that. However, on a short-term basis, the GDP growth for 2023 has been sharply scaled down from 1.2% to 0.5%, showing the impact of a likely slowdown.
   
    
2. Unemployment is expected to stabilize at around 4% in the long run. In the short run, the unemployment has been projected to rise in 2023 from 4.4% to 4.6%. However, this looks far-fetched considering that unemployment is at a 50-year low of 3.4%
   
    
3. The Fed has upped its PCE inflation projections and the core PCE inflation projections sharply for 2023 as compared to the projection in September 2022. However, Fed also projects the long term PCE inflation target of 2% by the year 2025.
   
    
4. Finally, on the Fed rates, there is a lot more front-loading as the Fed Fund rate projection for 2023 is raised by 50 bps to 5.1% compared to 4.6% made in September 2022. Also, the long run fed rate has been pegged at 2.5%.

To sum it up, there are hawkish hues to the Fed Monetary Policy Report. The first half of 2023 should give a clearer picture of the monetary policy trajectory.