Could July 2023 be the last Fed rate hike of this round?

21 Jul 2023 , 09:24 AM

Detailed surveys conducted by Reuters and Bloomberg indicate that economists expect the July 26, 2023 rate hike of 25 bps to be the last rate hike in this round. That means; rates in the US will peak in the range of 5.25% to 5.50%. The day after the US Bureau of Labour Statistics announced the 3% consumer inflation, the CME Fedwatch veered sharply left towards less hawkishness. Now, even the economists are veering around to the view that the Fed would not venture beyond 25 bps in July and will officially call an end to rate hikes. What are the implications? 

Damned if you do and damned if you don’t 

The Fed had been in a unique dilemma over the last 3 years. During the pandemic, 3 years ago, the US government and the Fed literally loosened its purse-strings. It resulted in an unprecedented influx of liquidity into the US and world economy which resulted in runaway inflation. Supply constraints only worsened the situation. Since the middle of 2021, most of the economists and policy watchers were exhorting the Fed to start hiking rates. However, the Fed waited all the way till March 2022 to start hiking rates. At that time, most people had protested that the government and the Fed were being too conservative about turning hawkish. However, the argument of the Fed at that point of time was that it did not want to upset the applecart of economic recovery as the world came out of a difficult period.

Of course, once the rate hikes began in March 2022, there was no relenting. In a span of just about 13 months, the Fed had hiked the rates by a good 500 basis points from the range of 0.00%-0.25% to 5.00%-5.25%. This time around, the criticism had veered around to the opposite direction. The general feeling was that the Fed was being too aggressive in front-ending rate hikes. The apprehension was that such an aggressive policy of tightening could actually lead to a massive economic slowdown, even throwing the US economy into a recession. Of course, the Fed had been steadfast that they would not relent until the consumer inflation went decisively towards 2%, supported by fall in core inflation. That is yet to happen, but consumer inflation has now gone 100 bps within the target range.

How economics confounded the economists

If ever a book was to be written about the macro movements in the last 3 years, this could be the title of the book. To cut a long story short, most economists have been absolutely confounded by how the US economy continue to remain resilient with historically low unemployment even 16 months after the US Fed embarked on one of its most aggressive rate hike campaigns in history. Obviously, there are no clear answers, but for the Fed there is one simple lesson. If something is too good to be true, then it is probably deceptive. The US economy has showed amazing economic mettle through one of the sharpest tightening cycles. However, the Fed also knows that it is not a wise decision to chance their luck for too long. They would rather step back, when the going is still good, as it is now.

Actually, it is actually too good to be true! Inflation is falling, with headline consumer inflation slowing to 3.0% in June from 4.0% in May and 4.9% in April 2023. The problem is that after 500 bps of rate  hikes, the Fed rates are already at a 22-year high. At this point, the GDP growth is still strong and the unemployment levels are in check. If you look at the March quarter (Q1GDP), the third and final estimate has come in at 2%, which is much better than expected. In terms of unemployment, it is still robust at 3.6%, indicating that the job markets continue to be undersupplied. However, the Fed also realizes that the rates are now at least 250 basis points above the neutral rate. That means any growth impact now will not be gradual but it would be sudden and cataclysmic. That is the eventuality that the Fed would want to avoid. After all, better to step back when the going is still good.

One rate hike or two rate hikes?

If you were to go by the testimony of the Fed chair, Jerome Powell, or the Fed governor, Christopher Waller, the choice is between 2 rate hikes and 3 rate  hikes of 25 bps each. However, while the Fed normally takes its communication very seriously, it has also been observed that around the critical turning points there is quite a gap between precept and practice. Fed would still want to come out with its held high that it contained inflation back to the pre-pandemic levels without impacting growth or jobs in a negative way. That would be a much better feather on the cap for the Fed than inflation control combined with the economy slipping into recession.

However, the pause in June may be the first indication that the Fed may be done for now and may not want to risk too much of hawkishness. Broadly, the Fed has two options for 2023. It can either guide for more rate hikes or it can raise rates just one last time and then guide for holding the rates  at that level for a longer period. What it could mean is that, the rates may stay in the range of 5.25%-5.50% for up to one year, with any rate cuts only likely in the second quarter of calendar 2024. That would be tantamount to keeping the monetary policy tight, without being obtrusively hawkish. That would also give enough time for the lag effects of the rate hikes to translate into lower inflation in the US economy. 

There is still a dichotomy since the member dot plot hints at rates peaking in the range of 5.50%-5.75%. However, less than 20% of the economists polled by Reuters believe that could actually happen. 

 

Are their risks to the possibility of rates peaking in July 2023?

In fact, there are several risks to the possibility of rates peaking in July 2023. Here are a few of the key risks, which may warrant more rate hikes.

• The first concern is that the fall in inflation may not be as quick as expected. After all, core inflation (which is more structural) is still at around 5% and expected to stay there. The Fed has already indicated that it would be closely watching core inflation too.

   

• Typically, the Fed relies less on consumer inflation (CPI) and more on the Personal Consumption Expenditures index (PCE). It actually has a target of PCE inflation touching 2.0%, but at 3.80% in May, the PCE inflation is still a full 180 bps away from target. Also, nobody expects, CPI, core CPI, PCE and core PCE inflation to reach 2% before 2025.

   

• Much of the fall in inflation in the last one year was led by energy inflation. There are two things that are changing on this front. Firstly, the oil price deflation is coming to an end with supply constraints and hopes of an economic revival. With Brent at above $80/bbl, there is a very strong possibility that energy inflation could bounce back.

   

• The biggest risk is that inflation control could happen but create recession in the process. That would be a huge cost to pay. For example, the latest Bloomberg Survey of economists is pencilling a 56% probability of recession in 12 months, 18% probability of a hard landing and just a 24% probability of a soft landing for the US economy.

Mao famously said, “a cat is a good cat, as long as it catches mice” and any policy is as good as its outcomes. Forget about the semantics; the Fed rate policy has surely delivered the goods. That is what matters in the ultimate analysis.

What it means to India if the Fed calls a halt in July?

As of now, it looks very likely that the July rate hike could be the last of the rate hikes in this round. Of course, the Fed will still keep its options open, but that would be more of a safe harbour provision. For the RBI, it would come as a relief if the Fed calls an end to rate hikes after the July hike. That will ensure that Indian real rates are still attractive and enticing from an investor perspective. That would ensure that the relentless flow of FPI money into India continues. That also ratifies India’s policy stance of holding rates since April.

For the RBI, the consumer inflation is likely to be volatile in the next few months due to erratic monsoons and pressure on food inflation. Too much hawkishness would have put pressure on the RBI to avoid monetary divergence. However, if the Fed gives a hint that hikes are over, it puts less pressure on the RBI when it comes to handling the short term food inflation challenge. That should help India’s cause too.