Fed minutes – still hawkish, but June could see a pause

25 May 2023 , 09:50 AM

While the RBI publishes the MPC minutes on the 14^th Day from the policy statement, the Fed publishes the FOMC minutes, 21 days after the policy statement. It may be recollected that the Fed repeated its 25 bps rate cut in May 2023, taking the benchmark rates to the range of 5.00% to 5.25%. Rates are now a full 500 basis points higher than the March 2022 levels. It must be said that inflation has responded quite well, although it is still off its targeted level of 2%. While the theme of the May policy statement was more inflation-obsessed, it emerges from the minutes that member discussions were a lot more optimistic and less hawkish.

When the policy statement was put out on 03rd May 2023, the theme was that the Fed would be officially done with rate hikes once inflation came down to 2% on a sustainable basis. The minutes indicate that even as the tone of the Fed remained hawkish, it has started hinting at being closer to the top of the interest rate cycle. That is a logical approach. After all, the advance estimates of GDP for the first quarter of CY2023 hints at a clear slowdown in growth. With the banking crisis on one side and the debt ceiling uncertainty on the other, the US markets are caught between the proverbial devil and the deep sea.  There seems to be a lot more pragmatism in the Fed tone as evident in the minutes of the FOMC.

Markets are now less optimistic about rate cuts in 2023

One of the standout themes in the last two months was the divergence between the Fed view and the market view as evinced by the CME Fedwatch. The Fed minutes underlined that while June could see a pause, rate cuts in 2023 were almost ruled out.

Fed Meet	325-350	350-375	375-400	400-425	425-450	450- 475	475- 500	500- 525	525-550	550-575
Jun-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	67%	33%	Nil
Jul-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	40.4%	46.5%	13.1%
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	10.5%	42.0%	37.8%	9.7%
Nov-23	Nil	Nil	Nil	Nil	Nil	7.1%	31.9%	39.2%	18.7%	3.1%
Dec-23	Nil	Nil	Nil	Nil	4.9%	24.1%	36.9%	25.1%	8.0%	1.0%
Jan-24	Nil	Nil	Nil	3.7%	19.6%	33.9%	27.9%	12.0%	2.6%	0.2%
Mar-24	Nil	0.4%	3.4%	18.2%	32.6%	28.4%	13.5%	3.5%	0.4%	Nil
May-24	0.5%	5.4%	20.1%	32.0%	26.4%	12.1%	3.1%	0.4%	Nil	Nil
Jun-24	3.9%	14.8%	27.7%	28.4%	17.3%	6.3%	1.4%	0.2%	Nil	Nil

Data source: CME Fedwatch

While the market continues to bet on rate cuts in 2023 and 2024, the Fed has cautioned not to expect any rate cuts in 2023. The latest CME Fedwatch shows that the market still expects rate cuts but is now less optimistic about it. Here are some key takeaways.

• The CME Fedwatch is building in a possibility of another 25 bps rate hike and an outside possibility of 50 bps from here. However, the probability of a pause in rates in the June 2023 policy has increased sharply to 67%.

   

• There is still divergence between the outlook of the Fed and the market on rates trajectory. However, the divergence is much lower. While the Fed has explicitly ruled out rate cuts in 2023, the market is now expecting only 25-50 bps rate cut in 2023. 

   

• The consensus emerging among the FOMC members is that peak rates could be about 25 bps from current levels. In fact, considering the weak growth, the banking crisis, and the debt ceiling uncertainty; a pause in June is a very likely scenario.

For now, the Fed has maintained its stance that inflation is not falling as fast as expected. However, members of the FOMC now want greater optionality to move both ways as warranted. Rate bias is more neutral now and the first test would be if there is a pause in the June 2023 policy. Based on the minutes, it looks a very likely scenario.

What we read in the Fed minutes for May 2023

One thing is clear from the minutes that officials are now more divided about the direction of interest rates. This ambivalence is good as it is likely to incorporate more diverse ideas in future debates. Here are some key takeaways.

1. The May Fed statement showed a unanimous decision to raise rates by 25 basis points. However, the minutes divulge that there was considerable disagreement among the members with a strong tilt towards a pause in June. The minutes specifically removed the phrase, “additional policy firming may be appropriate” from its statement.

    

2. According to the minutes, participants were uncertain about future trajectory of rates and suggested a more data driven approach. FOMC members focused on the need to retain optionality after this meeting. That means; the Fed must now be open to rate hikes, pause in rates or even rate cuts if warranted.

    

3. The minutes showed a clear divide between the hawks and the sceptics. The hawks feel that the progress on reducing inflation was still too slow and suggested more rate hikes. The sceptics were of the view that amidst slowing growth and a banking crisis, further rate hikes may not really be required.

    

4. FOMC minutes also show considerable debate over series of bank closures in recent months. The sceptics were of the view that system liquidity had to be ensured. Also, the banking crisis was partially hawkish as it had tightened credit. Hence, the FOMC must also ensure that too much hawkish does not translate into a recession. In fact, the FOMC members have flagged a strong possibility of recession starting in fourth quarter.

    

5. Members have also cautioned that if the debt ceiling was not raised on time, the resulting chaos could throw the monetary policy into a state of turmoil. That is because a likely default by the US would send US bond yields soaring and that would make the gradual inflation management redundant.

    

6. The broad majority view emerging from the meeting was that May 2023 could have been the last rate hike, with a low probability of further hikes. With the economy tipped to get into recession mode by the last quarter of 2023, the move towards 2% inflation target should be quick and also automatic. The members have called for greater optionality considering the very fluid macro situation in India.

    

7. A strong labour market, with record low 3.4% unemployment, has kept the pressure on prices. Interestingly, while the minutes refer to a recession in the fourth quarter, the high frequency indicators do not give any indication of the same. Even the second quarter GDP growth as per the Atlanta Tracker is pegged at 2.9%, against just 1.1% reported in the first quarter. Data is as ambivalent as it can get.

The moral of the story from the minutes is that the situation is very fluid and the Fed must keep an open mind with higher optionality at this point of time.

What the Fed minutes mean for India?

There is some good news and there is also some bad news. Like Marlon Brando suggested in the Godfather; “It is better to go with the bad news first.” The bad news is the high likelihood of a US recession in the fourth quarter. That could hit tech spending, exports and put pressure on growth considering the huge trade surplus that India runs with the US. The debt ceiling uncertainty is already a major headwind for Indian markets.

The good news is that global hawkishness may be coming to an end and if the Fed pauses in June, it will be the first affirmation. Dovishness has always suited India in terms of economic growth, stock market returns and portfolio flows. If that happens, it could be a positive tipping point for the Indian economy in general and Indian stock markets in particular.