Fed breaks the 75 bps habit; restricts to 50 bps in December

15 Dec 2022 , 09:22 AM

The Fed had previously hiked rates by 75 bps each in four consecutive meetings. However, he warned markets that rates could go much higher.

With the latest 50 bps rate hikes, the interest rates have scaled up to the range of 4.25% to 4.50%. Since March, the Fed has hiked rates by 425 basis points, with December showing a toning down of hawkishness. However, the statement hinted that the terminal rates would be much higher than originally anticipated and it is now being pegged at around 5.1%-5.3%.

Fed had given the first hint of toning down rate hikes after the October inflation had come in lower at 7.7%. Additionally, the December consumer inflation announced just a day before the Fed statement had come in another 60 bps lower at 7.1%. However, the Fed has cautioned that it would not release controls till inflation decisively headed towards 2%.

Reduced hawkishness coupled with higher terminal rates

Here is a quick look at the CME Fedwatch implied probabilities. With the latest rate hike of 50 bps in December, the Fed rates have risen from the range of 0.00%-0.25% to the range of 4.25%-4.50% between March 2022 and December 2022. Here are the implied Fed rate scenarios over next 8 meetings.

Fed Meet	375-400	400-425	425-450	450-475	475-500	500-525	525-550	550-575	575-600
Feb-23	Nil	Nil	Nil	75.0%	25.0%	Nil	Nil	Nil	Nil
Mar-23	Nil	Nil	Nil	28.5%	56.0%	15.5%	Nil	Nil	Nil
May-23	Nil	Nil	Nil	20.6%	48.3%	26.8%	4.3%	Nil	Nil
Jun-23	Nil	Nil	1.0%	22.0%	47.3%	25.6%	4.1%	Nil	Nil
Jul-23	Nil	0.2%	5.2%	27.0%	43.0%	21.4%	3.3%	Nil	Nil
Sep-23	0.1%	2.1%	13.5%	33.1%	34.8%	14.5%	2.0%	Nil	Nil
Nov-23	1.3%	9.0%	25.4%	34.1%	22.4%	6.9%	0.8%	Nil	Nil
Dec-23	8.1%	21.3%	31.9%	25.3%	10.8%	2.36%	0.2%	Nil	Nil

Data source: CME Fedwatch

In the November meeting of the Fed, Powell had given the first indication that the terminal rate would be above 5%. The December statement has given a clearer outlook, pegging terminal rates in the range of 5.00% to 5.25%. That opens the doors for the Fed to hike another 3 rounds of 25 bps each, which is what even the Fedwatch is indicating.

• As indicated by Powell, the rate hike intensity was reduced from 75 bps to 50 bps while the Fedwatch is hinting at three more rate hikes in 2023 of 25 basis points each. That would still take the terminal repo rates to the range of 5.00% to 5.25%.
• Based on Fed Futures indicated probabilities, the Fed could implement 3 rate hikes of 25 bps each in February, March and May 2023, which should be the peak rate. Fed futures even envisage rates coming down by September 2023, if growth gets impacted.
• If one looks at the latest consumer inflation imprint in the US, while food inflation and core inflation are lower, they are still too high by historical standards. It is energy inflation that is driving the fall in inflation, so Fed sees inflation staying sticky for longer.
• Like in 2022, even in 2023, the Fed is expected to front-load the 75 bps of rate hikes over 3 meetings. Despite lower intensity of rate hikes, the message is that Fed should most likely touch peak rates by mid-2023. That would give enough leeway to the Fed to take corrective action if required.

What perhaps disappointed the markets was that Fed is clearly not done with hawkishness, it is only reducing the intensity. Above all, the Fed is not relenting on inflation targets.

What we read from the December 2022 Fed statement

The message is almost doubled edged. On the one hand, the Fed has indicated that it is done with its ultra-hawkish stance. On the other hand, the message is also that it would not relent till the inflation came down decisively to 2% levels. Here are key takeaways.

1. While reducing the intensity of the rate hike, Fed chairman has underlined that a terminal rate of 5.00% to 5.25% range with target rate of around 5.10% looks more likely. However, the battle against inflation will go in an unrelenting fashion.
2. With likely neutral rates at 2.5%, the Fed rate at the current level is already 200 bps above the neutral rate. That is sufficient to push the inflation down rapidly, and the cumulative impact of all the hawkishness should be visible in coming months.
3. The terminal rate target of 5.1% is  now decisively higher than the originally indicated target of 4.6%. However, it also gives clarity that, except in special circumstances, the Fed should be done with rate hikes by the middle of 2023.
4. What one can infer from the Fed statement and the CME Fedwatch estimates is that the market is also pencilling in the possibility of rate cuts in the second half of 2023, if growth impact is too visible. For instance, year-end rates for 2023 are now being pencilled at an average of below 5%. That would be subject to growth impact only.
5. After the latest 50 bps rate hike in December, the Fed rates stands in the range of 4.25% to 4.50%. That is the highest rate in the last 15 years, with such levels only seen prior to the global financial crisis of 2007; not after that.
6. The dot plot chart drafted by the FOMC members shows that 17 of the 19 members have pegged the Fed rates at above 6% in 2023 with nearly a third of the FOMC members targeting rates to be at the higher end of the range at 5.25%. The projection for 2024, as per dot plot chart, is a fall in the Fed rates to 4.1% levels.
7. In a cryptic statement, Powell has warned that history is against any premature loosening of policy. Hence, the Fed would take any reverse decision only after being convinced that the inflation was decisively moving towards 2% target levels. One inflation warning is that core inflation target has been raised 30 bps to 4.8%.
8. Last, but not the least, Fed chairman is a lot more confident that the Fed can manage to avoid a hard landing. That confidence, perhaps, stems from the turnaround in the GDP growth to positive territory in the third quarter. That could drive rate action in H2-2023.

 
What is the Fed message for RBI and India

To be fair, the goals and priorities of the US and the Indian economy are at divergence. For India, it is growth above all else, while the US can afford to fight inflation for longer. The RBI has already reconciled to abstaining from rate hikes in its February MPC meet, irrespective of the FOMC outcome. The statements coming from the Fed would only encourage the RBI to reduce its accent on inflation and increase its accent on growth. The latest CPI and WPI inflation numbers in India only serve to underline this fact.

To the credit of the RBI, it has been quick to turn hawkish and also quick to refocus on growth. If 2022 was about synchronizing RBI monetary stance with the Fed, year 2023 may be about decoupling. That is the challenge that the RBI will have to pull off!