Fed hikes rates by 25 bps in July, signals a “Hawkish Hold”

27 Jul 2023 , 09:17 AM

When the Federal Open Market Committee (FOMC) hiked the rates by 25 bps on July 26, 2023, it came as little surprise. The rate hike was already factored into the market calculations with the CME Fedwatch having assigned a probability of more than 90% to a 25 bps rate hike in July, well ahead of the meeting. This marked the 11th round of rate hike by the Fed since it started raisin rates in March 2022. With the latest hike, the Fed rate has effectively moved from the range of 0.00%-0.25% to the latest range of 5.25%-5.50%. However, while the rate hike was factored in, the markets were actually expecting  a signal from the Fed that July 2023 would mark the end of this rate hike cycle. While the Fed did not give a direct signal, the hints were clear enough for economists to call it a Hawkish Hold.

As late as June 2023, the Fed had hinted at 2 more rate hikes of 25 bps each after it took a break in the June policy. However, with the lag effect of rate hikes pushing down consumer inflation to 3%, the Fed is officially just about 100 bps away from its avowed inflation target of 2%. The very fact that Jerome Powell spoke about rate cuts in 2024 is a hint that the Fed may not attempt more rate hikes in this year, unless the situation absolutely warranted. To that extent, the markets and the economists may be justified in believing that July could well have been the last rate hike in this round, under ceteris paribus conditions.

CME Fedwatch gives strong hints that rate hikes are done with

One way to look at the Fed outlook from a market perspective is the CME Fedwatch, which captures probabilities of rate levels after each Fed meet over next 1 year.

Fed Meet	350-375	375-400	400-425	425-450	450- 475	475-500	500- 525	525-550	550-575	575-600
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	78.0%	22.0%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	65.7%	30.8%	3.5%
Dec-23	Nil	Nil	Nil	Nil	Nil	Nil	8.3%	61.3%	27.4%	3.0%
Jan-24	Nil	Nil	Nil	Nil	Nil	2.9%	26.9%	49.4%	18.8%	2.0%
Mar-24	Nil	Nil	Nil	Nil	1.6%	15.9%	39.1%	32.9%	9.7%	0.9%
May-24	Nil	Nil	Nil	1.5%	14.8%	37.4%	33.3%	11.4%	1.6%	0.1%
Jun-24	Nil	Nil	0.7%	7.7%	25.4%	35.4%	23.0%	6.8%	0.9%	Nil
Jul-24	Nil	0.5%	6.3%	21.8%	33.3%	25.5%	10.1%	2.1%	0.2%	Nil
Sep-24	0.5%	5.3%	19.2%	31.4%	26.9%	12.8%	3.5%	0.5%	Nil	Nil

Data source: CME Fedwatch

What do we read from the CME Fedwatch probability shifts? Firstly, with the Fed rates already at the range of 5.25%-5.50%, the broad belief appears to be that the rate hikes in this round are done and dusted. Interestingly, the peak rate of 5.75%-6.00% now carried a very insignificant probability hinting that the markets do not consider that level likely. The only possibility left is a 25 bps hike to the level of 5.50%-5.75%. Even for that eventuality, the maximum probability is in the range of 25-30% only. Apparently, that assumes a serious spike in inflation, otherwise, the Fed may be done with the current rate hike.

What we read from the Jerome Powell statement

While we have to await the minutes of the Fed to get a clear picture of the discussions in the FOMC, the Fed statement issued by Jerome Powell is fairly explicit that the Fed is pleased with the progress made on containing inflation. The debate can continue on whether the Fed was too early or too late and whether front ending of rate hikes was a good idea. At the end of the day, it has contained inflation, and that is what matters. Here is what we read from the Fed statement on July 26, 2023.

1. In terms of his public statement, Powell has still maintained a cautious stance hinting that they would prefer to move meeting by meeting on a cautious basis. Fed was loath to committing  on the end of rate hikes as that would be too explicit a guidance and the Fed does take its communication very seriously. However, the fact that Powell spoke more about rate cuts next year next than about rate hikes this year, is a hint to the market that the Fed may be done with rate hikes for now.

    

2. Apparently, it is inflation that has done the trick. After sticking to their 2 rate hike stand in June, the language of the Fed appears to hint at rates topping out. For June 2023, the consumer inflation came in sharply lower at 3%, falling 190 bps between April and June. While the Fed remains concerned about core inflation being sticky and oil prices going up, the situation on the inflation front is a lot more under control now. Cost of funds is already at the highest level in 22 years and Fed obviously does not want to take too much of a risk from this point. Not surprisingly, markets are calling it a “Hawkish Hold.”

    

3. What we can decipher from the language of the Fed is that, from here on, the central bank may prefer to use the length of the pause as its strategy tool rather than using further rate hikes. Most economists have been predicting a recession in the US due to rate hikes. Till now, that has been avoided but the Fed would not want to chance its luck too far. After all, it is best for the Fed to exit its rate hike program at a time when it appears to have controlled inflation without negatively impacting growth and spending.

    

4. In terms of the totality of data flows, the Fed would be looking at 3 key data points viz. inflation, GDP growth and labour data. Let us start with labour data. Despite 11 rate hikes, the labour data continues to be robust with just about 3.6% unemployment, still an economic signal of full employment. GDP growth picked up to 2% in Q1 and Q2 is expected to show growth of 2.4%. If the US economy even meets these numbers, it would give the Fed some solace that growth has not been impacted. Inflation remains the data riddle for the Fed. It would be looking close at the 3 component viz. food, fuel, and core inflation. However, the next trigger would come from the PCE (personal consumption expenditure) based inflation that will be announced later this week.

    

5. Markets did express disappointment that Powell did not give any commitment on rates. However, that is a logical move and with macro factors so delicately poised, giving any communication on rates could be counter-productive. It may not want to do that till inflation shows a visible and decisive sign that it is headed lower. For the Fed, a data dependent approach has worked well and that is what they will continue with. However, there are enough indications that the Fed does not intend any more rate hikes in this round, unless a sharp bounce in inflation really warrants the same.

    

6. An interesting shift in the policy statement was on the outlook for GDP growth. The Fed statement upgraded the outlook for GDP growth from Modest to Moderate, largely an indication that prospects of recession were receding. Going ahead, the Fed may tackle routine economic issues through a longer pause to the extent possible. Rate hikes from the current levels would only be an exceptional intervention if the situation really warranted the same. That is the key message that has come from the Fed statement.

    

7. The one concern for the Fed could be that consumer headline inflation may the most benign of the variables and hence must be taken with a pinch of salt. For example, full year inflation is still being pegged at 3.4% headline and 4.9% core inflation. Also, the PCE inflation, which the Fed uses for its rate decisions, has only fallen to 3.8% on headline and 4.6% on core as of May 2023, with June 2023 data still awaited.

    

8. One piece of good news is that the Fed has also been gradually cutting down on its bond holdings from $9 trillion to $8.32 trillion. That has also been contributing to the tightening of market liquidity. If you also add up the bank credit tightening then the effective rate hikes would be higher than what the numbers show. That could tilt the balance in favour of status quo on rates in the remaining FOMC meetings of 2023.

Markets are likely to latch on to the one cryptic statement made by Powell in his post policy conference, “It is possible that Fed would choose to hold steady and as we make careful assessments, meeting by meeting.” That is being seen as the surest indication that two rate hikes left for this year, as suggested in June, might end up being just one. 

What does Fed policy statement mean for RBI?

It may be too early to call it the end of the rate hikes in the US. However, there are enough reasons for the RBI to use that as the default interpretation. For now, the RBI will stick to that assumption. That means, the RBI has less to worry about global monetary divergence. That also means that the RBI can pursue its best case monetary  approach, without worrying about the divergence risks. 

RBI had effected its last rate hike in February and has been on hold since then. However, food inflation has spiked in June due to erratic monsoons and the spill over impact on inflation will be visible in July and August also. It remains to be seen how the RBI tackles the situation. However, the real question would be if the bond taper would hit liquidity from passive funds. For now, FPIs are coming into India by the hordes and such concerns are not visible. That is the good news.