Fed minutes finally hint at rates peaking in the US

19 Mar 2024 , 10:32 AM

Fed game plan on rate cuts remains elusive

When the Fed announced the Monetary Policy on January 31, 2024, one thing was underlined. Rate cuts in March were ruled out. In retrospect, the Fed may have been right. The consumer inflation for January 2024, announced by the US Bureau of Labor Statistics earlier this month, had pegged the rate of inflation at 3.1%. This may have been lower than 3.4% in December, but was 20 bps higher than the Bloomberg estimate of 2.9%. In short, the consumer had made a case for the Fed to be more conservative about rate cuts, although one can argue that it is the PCE inflation that the US Fed considers. 

What we read from the minutes was that the Fed continues to be ambivalent about the timing of commencement of rate cuts. However, it has not changed its guidance of 3 rate cuts in the current calendar year. However, the Fed has maintained its stand that it would still need to see clear indication that inflation was coming down in the US economy. However, there are 2 interesting things that emerged from the Fed minutes announced late on February 21, 2024. Firstly, the Fed did give a clear indication that rates had peaked; meaning rate hikes were done and dusted. Secondly, the Fed also hinted that it would go slow on tapering the bond book to ensure that it did not indirectly magnify hawkishness.

Four major highlights of the Fed January 2024 meeting minutes

The reaction of the markets to the Fed minutes of the January 30-31 FOMC meeting was muted. Here are 4 key highlights of the minutes published on February 21, 2024.

• The Fed continues to be concerned about the pace of growth in GDP. For the fourth quarter of 2023, the first advance estimates of GDP growth stand at 3.3%, which is much higher than expected. The Atlanta Fed projections for Q1 GDP projections for 2024 also stands at above 4%. The concern for the Fed officials is that, at such elevated levels of GDP growth, it was not possible to rapidly control inflation. 

   

• What is evident from the FOMC minutes is that the Fed will have to see more concrete and tangible evidence of inflation coming down in a sustainable manner. There is the core inflation indicator that has been falling, but the core inflation stagnating in January at 3.7% was rather disappointing for the Fed. For now, the Red Sea crisis is imputing a hidden cost on the US core inflation and that is something the Fed is clearly wary of.

   

• The Fed statement, “Participants generally noted that they did not expect it would be appropriate to reduce the target range for the federal funds rate until they had gained greater confidence that inflation was moving sustainably toward 2%” had two interpretations. It could be interpreted as a cautious move, but also as an indication that rates may have peaked out; and rate hikes were off the table for the time being.

   

• With the Fed having scaled down its balance sheet by nearly $1.50 trillion since the post-COVID peak, there are enough indication in the minutes that the Fed may now go slow on its bond book taper. It may still want to bring the book down to the pre-COVID level of $4.5 trillion, but it would want that to happen in a way that domestic liquidity does not become too tight.

The tepid reaction of the US bond yields and the equity indices post the minutes indicate that the minutes did not have too many insights beyond what was in the Fed Statement.

CME Fedwatch almost veers around to the Fed view

One way to look at the Fed outlook from a market perspective is the CME Fedwatch, which captures probabilities of the Fed rate levels after each Fed meet over next 1 year. One big question after the minutes is; is whether CME Fedwatch is being optimistic or pessimistic?

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Mar-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	6.5%	93.5%
May-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	1.6%	27.4%	71.0%
Jun-24	Nil	Nil	Nil	Nil	Nil	Nil	0.9%	17.1%	53.5%	28.5%
Jul-24	Nil	Nil	Nil	Nil	Nil	0.6%	11.3%	40.4%	37.5%	10.2%
Sep-24	Nil	Nil	Nil	Nil	0.5%	8.7%	33.4%	38.2%	16.8%	2.5%
Nov-24	Nil	Nil	Nil	0.2%	4.9%	21.9%	35.8%	26.7%	9.2%	1.2%
Dec-24	Nil	Nil	0.2%	3.4%	16.5%	31.4%	29.7%	14.8%	3.7%	0.4%
Jan-25	Nil	0.1%	2.1%	11.1%	25.2%	30.4%	20.9%	8.3%	1.8%	0.2%
Mar-25	Nil	0.9%	5.6%	16.7%	27.3%	26.6%	15.9%	5.7%	1.1%	0.1%
Apr-25	0.6%	3.8%	12.4%	23.2%	26.9%	20.1%	9.7%	2.9%	0.5%	Nil

Data source: CME Fedwatch

What has changed post the minutes? In fact, in the last few weeks, the CME Fedwatch had been consistently veering towards the Fed stated point of view. This week, that has become a lot more prominent. On the upside, the CME Fedwatch and the Fed are now in concurrence that rates may have peaked, barring some very exceptional circumstances. Hence, any rate hikes were ruled out and the Fed would, at best, prefer to hold rates higher for longer, rather than hiking rates. However, the real shift has happened on the downside and that trend has got accentuated post the minutes of the Federal Reserve on Wednesday.

Let us turn to the divergence on the downside. The Fed had pegged rates to be cut 3 times in 2024 and another 4 times in 2025. However, initially, the CME Fedwatch had pegged the entire 7 rate cuts of 175 bps to happen in the year 2024 itself. Over the last few weeks, the cautious Fed policy statement and higher inflation have gradually brought the CME Fedwatch estimates closer to the Fed viewpoint. Now the CME Fedwatch expects only 3 to 4 rate cuts in 2024 and that too it is assigning a 50:50 probability to both the outcomes. By April 2025, the CME Fedwatch is expecting between 4-5 rate cuts, with a 70% probability to 5 rate cuts. In short, the CME Fedwatch appears to have fully turned around to the Fed point of view. With the Fed taking its communication very seriously, that had to happen.

What we read from the minutes of the January Fed meet

In a sense, the minutes of the FOMC meet largely reiterated its stance expressed in the Fed statement on January 31, 2024. However, there are some readings that emerge clearly from the minutes of the US Fed. 

1. In the Fed statement on January 31, 2024, the Fed had decided to leave the key overnight borrowing rate unchanged but also underlined that that no cuts would be coming until the rate-setting Federal Open Market Committee had “greater confidence” that inflation was receding. In fact, the Fed had explicitly ruled out rate cuts in March. The priority for the Fed would be to assess if data hinted at inflation moving to 2%.

    

2. There was a sense of optimism in the FOMC minutes on two fronts. Firstly, there was a general sense of optimism that Fed policy moves had succeeded in lowering inflation after it had touched a 40-year high in mid-2022. There was also optimism that further rate hikes would not be necessarily, hinting that rate hikes may be done with. However, the Fed was waiting for more evidence on inflation, before starting to ease on rates.

    

3. An interesting word used in the policy minutes was the reference to “idiosyncratic” factors that will not last for long. Clearly, the FOMC minutes were talking about the elevated inflation risk on account of the Red Sea crisis and the need for ships to traverse the much longer Horn of Africa route. However, the FOMC has also expressed hope that this would be an ephemeral problem, and unlikely to persist for too long.

    

4. On the way up,  the Fed was accused of being late in starting the rate hike program, although the Fed had its own reasons. However, on the downside, the Fed wants to be a lot more calibrated. The FOMC minutes clearly indicated that even in the rate hike process, Fed assessment may have been off, but its strategy was on target. On the downside, the Fed does not want to take chances without data to back up its stance.

    

5. FOMC minutes show that members are still concerned that the impact of elevated inflation continued to harm households with limited means to absorb higher prices. For the Fed, there is inflation and there are also inflation expectations; and it wants to see both coming down. Fed, apparently, wants to be doubly careful on the way down and any wrong call could have an impact on the economics of American households.

    

6. The one thing that has contributed to the uncertain outlook of the Fed is the divergence between the consumer inflation (CPI) and the producer inflation (PPI) in the US. While the consumer inflation is falling, the PPI has been showing some pressure. This tends to eventually rub off on the CPI inflation, which is why the Fed is taking longer to take a final view on the timing of rate cuts. 

    

7. One of the concerns for the Fed has been that the US labour market continues to show signs of expanding at a very brisk pace. The US economy added 3,53,000 non-farm payrolls in January and unemployment continues to stay close to 3.7%. The impact is visible in the optimistic GDP estimates in the FAE and also in the Atlanta Fed GDP estimates. Strong labour market remains a major concern for the Fed on inflation.

    

8. Finally, the FOMC minutes have underlined the term “ample reserves” referring to the liquidity tightness caused by the Fed tapering the bond book. In the last 18 months, the Fed has tapered its bond book by nearly $1.50 trillion. Initially, it helped to magnify the effects of rate hikes, but now the Fed is concerned that staying too tight may delay rate cuts by the FOMC. Fed is likely to call off bond book tapering for some time; or at least reduce the pace of tapering from the current $95 billion a month.

One statement by Jerome Powell still resonates in the minds of markets, “The move in interest rates will be down, but Fed needs more evidence that inflation is moving sustainably lower.” At the current juncture, the inflation trajectory is the X-factor. On way the markets are interpreting the minutes is that, rate cuts are surely coming this year; just that they have been back-ended for now. Traders are cautious that the first rate cut may only happen in June and the CME Fedwatch data is also backing these voices.

How will the RBI interpret the Fed January minutes?

RBI effected its last rate hike in February 2023 and has since held rates static for the next 6 meetings. The good news for the RBI is that the consumer inflation has fallen in the month of January from 5.69% to 5.1%. What is even better is that this has been led lower by structural core inflation. The reason the RBI may want to pat itself its back is that it has contained inflation without impacting GDP growth, which continues to be robust at above 7%. The trend is likely to continue in FY25 also. With robust GDP numbers and strong core sector growth, the RBI has less to really worry on the growth front.

With RBI holding status quo on repo rates since February 2023, it looks like rate hikes are done and dusted. However, there is a strong case for the RBI to cut rates for two reasons. Firstly, the current repo rates at 6.5% are a full 135 bps higher than the pre-COVID interest rates of 5.15%. Secondly, if you look at the bond yields of 7.2% on the 10-year benchmark and the average inflation at 5%, the real rate of yield is unsustainably high at 2.2%. The latest minutes of the Fed are unlikely to change these ground realities beyond a point. RBI would be happy that the Fed has called peak on rates, although the rate cut timetable will be of a lot more interest to the RBI.