The ECB has just hiked rates by 50 basis points for the first time since 2011. The US Federal Open Markets Committee (FOMC) is meeting on 26th and 27th July to decide on rate action. Between 03rd and 05th August, the RBI Monetary Policy Committee (MPC) will meet to set rates in India. But for now, the billion dollar question is whether the Fed would hike rates by 75 bps or 100 bps when it meets next week.
While the US consumer inflation at 9.1% for June 2022 made a case for a 100 bps rate hike, FOMC members are increasingly veering towards a more calibrated approach to rate hikes. Their apprehension is that if the rates are hiked rapidly and inflation is not controlled, it may impact the credibility of the Fed, which is bad. It could also result in a recession if the rates are too much above the neutral level of 2.50%, which is worse. It is between these two extreme views that the FOMC will take its decision on 27th July.

How Fed will handle the dual mandate?

The Federal Reserve currently has the dual mandate of ensuring maximum employment as well as price stability (regulated inflation). However, these two mandates can often be at cross-purposes and this is all the more stark at the current juncture. Currently the US economy is enjoying high employment but that comes with high inflation. That opens up two quandaries. Firstly, if the employment demand is more than supply, then high rates may not necessarily cool inflation. Secondly, since the US recovery is still nascent, the Fed would not want too much of inflation control to result in recession and loss of jobs.

While there are no simple answers, there were some specific insights on this subject coming from Governor Christopher Waller, when he addressed the Rocky Mountain Economic Summit. The only guide we have now is the CME Fedwatch, which is currently assigning a probability of 71.5% to a 75 bps rate hike and a 28.5% probability to a 100 bps rate hike. At least, the market believes that the bias of the Fed will be towards 75 bps only.

Inflation reduction remains the focus

In his speech, Chris Waller has underlined that controlling inflation and ensuring price stability will continue to remain the underlying theme of the Fed strategy and that would amply reflect in the July 2022 policy. Waller has highlighted that the biggest burden of inflation fell on the lower and moderate-income households that normally dedicate a larger share of their spending to necessities. As Waller rightly pointed out, managing inflation becomes critical for one more reason i.e. to effectively manage inflation expectations.

The crux of the debate is not about whether rate hikes beyond a point will reduce inflation? It has empirically proven that it will reduce inflation. The only concern is that, once the rates cross the tipping point, the negative impact on output and jobs may outweigh the positive impact of lower inflation. That is the real debate, which leads to whether the Fed would cut rates by 75 bps or by 100 bps in its July policy meet. The gist of Waller’s contention is that the two need not be in conflict and inflation can be controlled without compromising either on GDP growth or on employment levels.

But GDP has contracted for two quarters?

One of the popular measures of GDP momentum is the Atlanta Fed’s GDPNow, which captures real time data-driven projections of GDP growth in the US on a quarterly basis. US has seen -1.6% contraction in the March 2022 quarter and the early estimates of June 2022 quarter is of a -2.1% contraction. That is where, Waller sees a major dichotomy between the market view and the Fed view.

According to Waller, in such uncertain times, the Gross Domestic Income (GDI) gives a more realistic picture of growth compared to the GDP. For the first quarter ended March 2022, while GDP contracted -1.6%, the GDI actually expanded by 1.8%. According to Waller, the past experience has been that when there were such wide gaps between GDP and GDP, the two eventually converge. As Waller has explained, the negative GDP growth in the March 2022 quarter can be largely attributed to unusual trade-related reasons in the first quarter that are unlikely to be repeated. That is neutralized in the GDI calculations, which is why Waller gives more credence to GDI over GDP data.

One classic example is the shift from spending on goods to spending on services.

Focus will remain on persistently high inflation

Waller has highlighted that the focus will be inflation; first and foremost. With yoy consumer inflation at 9.1% for June 2022, it is consistently at a 41-year high. Waller has underlined that the Fed was committed to 2% inflation target in the medium term. As Waller admits, there are challenges to a rate hike driven philosophy. For instance, chunk of the current inflation is driven by supply side bottlenecks. Even, tight labour markets have contributed to the high inflation. Excess savings during the pandemic, combined with fiscal stimulus, boosted demand.

To quote Waller, “When your goal is price stability, you just want to reduce excessive inflation, irrespective of whatever the source lies in supply factors or demand factors. The bottom line is that high inflation reading would push up inflation expectations and in-turn keep prices high. That is the kind of vicious cycle that the Fed wants to avoid. For that, an aggressive rate hike policy should work very well.

Monetary policy ahead: 75 bps or 100 bps?

Since March 2022, Fed has raised rates by 150 bps, which includes the liberal 75 bps rate hike in June. For the July policy, the debate is over 75 bps versus 100 bps. According to Waller, higher rates will stifle business, but will not kill business. For example, after the June rate hike, home mortgage rates went up by 200 bps and there was also some slowdown in home sales. However, lenders and borrowers were still doing business, which indicates that markets were convinced about FOMC’s policy intentions.

Waller has underlined that 75 bps rate hike should do the job as it would take rates to the range of 2.25% to 2.50%; very close to the neutral rate that neither restricts demand not stimulates. However, he has also highlighted that a larger rate hike of, perhaps 100 bps, maybe warranted if retail sales and housing data showed that demand was not slowing adequately. At the end of the day, two words hold the key to rate hikes; the need to bring down inflation swiftly and decisively.