"Fed Jhukega Nahi" - Inflation control at any cost

16 Jun 2022 , 11:02 AM

The Fed has been prismatically building up pressure on markets via monetary tightening. It raised rates by 25 bps in March, 50 bps in May and now by 75 bps in June 2022. Effectively, Fed has raised rates by 150 bps since March taking the Fed rates to the range of 1.50% to 1.75%. But that is just part of the story. The bigger story is that the Fed continues to be very hawkish and has promised hefty rate hikes in the remaining 4 FOMC meetings in year 2022.

This hawkish stance is not without reason. For the month of May 2022, consumer inflation in the US came in at a 40-year high of 8.6%. That is 30 bps more than the inflation reported in April 2022. What would really worry the Fed is not fuel inflation, but double-digit food inflation. Food inflation hits vulnerable sections of the economy and is considered unjust.

But, markets were actually impressed! Dow rallied 1% on Wednesday despite hawkishness while NASDAQ rallied 2.5%. Hawkish central bank stance represents robust economic growth and that was seen as positive news flow. Even the 10 year bond yields fell sharply from 3.47% to 3.31%. The Bloomberg Dollar Index (DXY) tapered post the FOMC decision from 105.70 levels to 104.87 levels. Markets have taken the rate hike in the stride.

CME Fedwatch hints at 3.40%-3.50% target rate by end of 2022

CME Fedwatch captures probability of rate hikes at future meetings based on the yields implied in Fed Futures trading. Here are implied Fed rate scenarios over next 9 meetings.

Fed Meet	200-225	225-250	250-275	275-300	300-325	325-350	350-375	375-400	400-425	425-450	450-475
Jul-22	21.0%	79.0%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Sep-22	Nil	Nil	14.3%	60.4%	25.3%	Nil	Nil	Nil	Nil	Nil	Nil
Nov-22	Nil	Nil	Nil	5.4%	31.6%	47.25%	15.8%	Nil	Nil	Nil	Nil
Dec-22	Nil	Nil	Nil	Nil	3.6%	22.8%	42.0%	26.3%	5.3%	Nil	Nil
Feb-23	Nil	Nil	Nil	Nil	1.2%	10.2%	29.5%	36.6%	19.0%	3.5%	Nil
Mar-23	Nil	Nil	Nil	Nil	0.6%	5.9%	20.1%	33.1%	27.6%	11.0%	1.7%
May-23	Nil	Nil	Nil	Nil	0.6%	5.4%	19.0%	32.1%	28.0%	12.4%	2.5%
Jun-23	Nil	Nil	Nil	Nil	1.7%	8.3%	21.7%	31.2%	24.7%	10.3%	2.0%
Jul-23	Nil	Nil	Nil	Nil	3.8%	11.6%	24.1%	29.6%	21.1%	8.2%	1.6%

Data source: CME Fedwatch

Normally a probability in the range of 25% to 30% is a strong indication of affirmative action.

·         With the Fed gradually increasing the intensity of rate hikes, it looks like the Fed will only intensify its hawkishness amidst record high inflation.

·         Fedwatch pegs the interest rates in the range of 3.50%-3.75% by December 2022. The dot plot is also indicating rates at 3.40%-3.50% by end of December 2022.

·         With another 175 bps to go over the next 4 meetings, markets are expecting even the July meeting to see 75 bps rate hike before tapering from September onwards.

·         The consensus long-term rate which was around 3.25%-3.50 after the last Fed meet in May, has moved up to 4.00%-4.25% in terms of long term target.

·         In short, the CME Fedwatch is expecting the rate hikes to be front ended in 2022 itself with 2023 being used more as a review of further feasibility.

All this is assuming that growth does not see a major dent since that would become a case of the remedy being worse than the disease.

Key takeaways from the June 2022 Fed statement

The Fed statement by Jerome Powell on 15th June had 2 distinct messages. Firstly, the focus would be inflation control, even at the cost of growth. Secondly, large chunk of the Fed rate hikes would be front-ended in 2022.

a)      The 75 bps rate hike in June 2022 was the largest single up-move in rates in the last 28 years. The last time the Fed undertook a 75 bps rate hike was in 1994. Unprecedented times call for unprecedented measures.

b)      With consumer inflation touching 8.6% and food inflation in doble digits, the Fed wants to protect the most vulnerable sections of the American economy. It will be rate hikes and hawkishness, even at the cost of GDP growth.

c)      There has been a shift in interest rate targets as of the June FOMC meet. Now, the consensus rates by December 2022 are pegged at the range of 3.4% to 3.5% while the consensus peak rates are pegged closer to 4.25% as the eventual target.

d)      Fed expects that as a result of these hawkish policy measures, inflation would drop to 4.3% by December 2022, 2.7% by end of 2023 and to 2.3% by the end of 2024. The long term median inflation target for the US stays at 2%.

e)      On bond unwinding, the Fed has signalled the start of bond unwinding with $47.50 billion unwinding in June 2022; scaled up to $95 billion by September 2022. This would comprise of $30 billion of treasuries and $17.5 billion MBS.

f)       The Federal Reserve is wagering that its ultra-hawkish approach will help restore some balance to the labour market, unemployment levels are seen 20 bps higher at 3.7% by December 2022 compared to the earlier forecast of 3.5%.  

g)      The Fed has made a pragmatic cut in growth outlook due to monetary tightening. The consensus indicates that while recession will be avoided, GDP growth would taper to 1.7% in 2022, against the prior forecast of 2.8%.

The big challenge for the US economy would be to ensure that the sharp rate hikes do not result in a recession and a slowdown in the investment cycle. That would be too huge a price to pay for inflation control. For now, hawkishness is a Hobson’s choice for the Fed.

What does Fed hawkishness mean for India?

There were always 3 concerns for the RBI. The first was to ensure that the real rates in India were attractive vis-à-vis the US. That is still the case due to the inflation gap. Secondly, liquidity could be impacted by the bond book unwinding. However, with $28 billion having already flown out of India since October 2021, the incremental risk is limited. Thirdly, a recession had to be avoided and that remains the big challenge and we will get clarity in the coming months.

If the Fed has hiked rates by 150 bps since March, RBI has raised rates by 90 bps and also pushed up CRR by 50 bps. For May 2022, Indian consumer inflation is a full 156 bps lower than the US consumer inflation. RBI is in comfort zone, but in this volatile market things have the habit of changing at short notice.