Fed minutes hint that rates may go well beyond neutral zone

7 Jul 2022 , 10:20 AM

Fed has already hiked rates by 25 bps in March, 50 bps in May and another 75 bps in June; taking Fed rates higher by 150 bps in a quarter to the range of 1.50% to 1.75%. But the Fed is far from being done.

The FOMC minutes underline that the Fed is betting on a very high probability of 50 bps to 75 bps hike in July and September. In fact, now the choice in front of the Fed is between 50 bps and 75 bps in the next 2 meetings and may tone down after that depending on the rate of inflation. Not much change can be expected unless there is a drastic fall in inflation.

One important aspect of Fed policy was always going to be how much beyond the Fed neutral rate it will traverse in 2022. The Fed neutral rate is 2.5%, which is the rate up to which inflation can be controlled, without impacting GDP growth. Beyond that level, GDP takes a hit. In 2022, Fed plans to go at least 90 bps above neutral rate to 3.40% or more.

CME Fedwatch is hinting at 90-100 bps above neutral rate by 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	9.1%	90.9%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Sep-22	Nil	Nil	7.8%	79.5%	12.7%	Nil	Nil	Nil	Nil	Nil	Nil
Nov-22	Nil	Nil	Nil	5.1%	54.8%	35.7%	4.4%	Nil	Nil	Nil	Nil
Dec-22	Nil	Nil	Nil	1.5%	19.2%	49.4%	26.8%	3.1%	Nil	Nil	Nil
Feb-23	Nil	Nil	Nil	1.1%	15.3%	42.7%	31.8%	8.3%	0.7%	Nil	Nil
Mar-23	Nil	Nil	Nil	1.1%	15.3%	42.7%	31.8%	8.3%	0.7%	Nil	Nil
May-23	Nil	Nil	0.5%	7.4%	27.4%	37.9%	21.5%	5.0%	0.4%	Nil	Nil
Jun-23	Nil	Nil	0.5%	7.4%	27.4%	37.9%	21.5%	5.0%	0.4%	Nil	Nil
Jul-23	Nil	0.3%	4.8%	19.8%	33.9%	27.7%	11.2%	2.1%	0.1%	Nil	Nil

Data source: CME Fedwatch

Apart from the regular hawkishness, there are some interesting trends emerging.

• In the short term, the Fedwatch assigns a 91% probability of 75 bps rate hike in July FOMC meet and an 80% probability of another 50 bps rate hike in September 2022.
• With Fed rates at 2.75% to 3.00% by September, the Fed is likely to push rates by another 50 bps in the November and December 2022 meetings.
• In short, the Fedwatch expects to be 90-100 basis points above the neutral rate of 2.5% by end of year 2022; which is what even the Fed has been indicating.
• There has been an interesting fall in the consensual long term rate forecast from 4.25% to a worst case scenario of 3.75%, including possibility of rate cuts in 2023.
• While the story of Fedwatch is still one of front-loading rate hike, there is an increasing feeling that growth concerns may force a change of strategy in 2023.

For the first time, the Fedwatch has hinted at the possibility of a reversal in the rate hike cycle in 2023 if recession starts to pinch. That is an
interesting deviation.

Key takeaways from the minutes of June 2022 FOMC meeting

The FOMC minutes were announced at a time when the US economy is up against diverse forces. On the one hand, consumer inflation continues to be elevated at above 8%. On the other hand, the GDPNow indicator has given the first signs of 2 consecutive quarters of negative growth in the US real GDP. Here are the major takeaways from the FOMC minutes.

1. If one were to summarize the FOMC minutes, there is not much of a change in the short term stance. The Fed is still prepared to hike rates by 50 bps or 75 bps in the July and September 2022 meetings. It has hinted at “more restrictive stance” if required.
2. The FOMC focus, according to the minutes, was still on the need to fight inflation, even if it meant slowing the economy. That shows why the Fed consciously is willing to take the Fed rates even 90 to 100 bps above the neutral rate of 2.5% by the end of 2022.
3. FOMC has maintained that it would not change policy tack unless inflation got closer to the targeted levels of 2%. While that may sound a steep target, a lot of that would have been achieved in the sharp fall in commodity prices in the last couple of weeks.
4. Interestingly, the FOMC minutes has acknowledged that a grossly restrictive policy could come with a price but the committee was willing to adopt a restrictive stance to bring down 8% plus inflation. That could come at the cost of GDP growth.
5. For the Fed it is not just about fighting inflation but also to be seen fighting inflation. In terms of Fed credibility, the June FOMC meeting rightly mentioned that Fed had to assure markets and the public that they were dead serious about fighting inflation.
6. The dilemma between inflation and growth is likely to come up sooner rather than later. Real GDP of the US economy contracted by -1.6% in the March 2022 quarter and as per the Atlanta Fed GDPNow indicator, it looks all set to contract by -2.1% in June quarter.
7. The sustained hawkish policy of the Fed, even at the cost of growth, has also created the anomalous situation of an inverted yield curve wherein the yields on the 2-year benchmark bond is higher than on the 10-year bond, hinting at a likely recession.

The gist of the FOMC minutes is that it remains hawkish for 2022, but could see a change of heart in 2023, should growth pressures escalate beyond a point.

What India must read from the FOMC minutes?

Should the RBI also follow a hawkish stance of monetary policy, like the Fed? In the Indian case, there are a number of imponderables. Firstly, inflation continues to be elevated in India too. However, the jury is still out on whether rate hikes are the answer to higher inflation that is supply driven. Also, the sharp fall in commodities in the last few weeks, should have moderated inflation.

We have a situation in the world, where many of the global economies are not yet buying the tightening argument. As of now, India still remains neutral. What remains to be seen is whether RBI continues its hawkish stance even after the 110 bps rate cut of the pandemic are reversed. The next few months will throw some interesting policy choices for India.