Fed minutes hints at one rate hike, but a longer elevated pause

12 Oct 2023 , 10:38 AM

Fed minutes display mildly hawkish narrative

The Fed minutes of the FOMC September 2023 meet, came exactly a day before the consumer inflation for the month was to be announced. However, the minute largely tell the story that was already apparent in the Fed statement made by Jerome Powell, 21 days ago. The Fed typically publishes the minutes a full 3 weeks after the Fed meet. The gist of the Fed minutes is that most members may have differed on rate hikes, but there seems to be a consensus on the need to hold rates at elevated levels for a longer period; or a longer pause as it is being called. The minutes also indicate that inflation should remain at higher levels for a longer period and that would rule out any rate cuts for the time being.

After touching a low of 3% in June 2023, the consumer inflation in the US bounced to 3.7% in August 2023. September inflation is expected to be marginally lower, but it is still far away from the avowed fed target of 2% inflation. One can argue that it is PCE inflation that sets the tone for Fed policy, but consumer inflation normally is the lead indicator. The Fed believes that its battle against inflation is not done yet; and they may be right, especially in the light of the ongoing strife in West Asia and its likely impact on crude oil prices. Two things emerge from the minutes. Firstly, the future strategy would be to be implement hawkishness via longer pause than a rate hike. Secondly, the Fed will continue to keep price stability as its central goal and monetary policy will be built around that.

CME Fedwatch is more optimistic than the Fed

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
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	91.5%	8.5%	Nil
Dec-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	72.1%	26.1%	1.8%
Jan-24	Nil	Nil	Nil	Nil	Nil	Nil	4.5%	69.3%	24.6%	1.7%
Mar-24	Nil	Nil	Nil	Nil	Nil	1.2%	22.0%	57.2%	18.4%	1.2%
May-24	Nil	Nil	Nil	Nil	0.5%	9.6%	36.2%	41.6%	11.5%	0.7%
Jun-24	Nil	Nil	Nil	0.2%	4.7%	22.0%	38.7%	27.5%	6.4%	0.4%
Jul-24	Nil	Nil	0.1%	2.7%	14.4%	31.3%	32.4%	15.7%	3.1%	0.2%
Sep-24	Nil	0.1%	1.6%	9.4%	24.1%	32.0%	22.9%	8.5%	1.4%	0.1%
Nov-24	Nil	0.9%	5.5%	16.8%	28.0%	27.4%	15.7%	4.9%	0.7%	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%, another 25 bps hike this year now looks like a worst case scenario. That is something on which the CME Fedwatch and the Fed communication appears to be in sync. Secondly, the CME Fedwatch is factoring in peak rates of below 6%, although we are yet to get confirmation from the Fed on this. Thirdly, the CME Fedwatch appears to be a lot more optimistic about rate cuts as compared to the Fed and the CME Fedwatch is even factoring in 75 bps to 100 bps rate cut by end of 2024. 

However, the Fed is not willing to commit anything more than 50 bps rate cut by end of 2024. Where the CME Fedwatch and the Fed communication tend to agree is that the undertone of monetary policy in future would be to pause rather than hike rates, if the situation demanded a hawkish response from the Fed. Clearly, at 5.25% to 5.50% rates, the Fed is also choosing to tread more carefully due to the magnifying impact that rate hikes can have on growth.

What we read from the October Fed minutes

The Fed minutes largely were in sync with the Fed statement and the subsequent series of communications that the Fed members have made. Here are some key takeaways we gathered from the Fed minutes announced on October 11, 2023. 

• At a theoretical level the Fed officials differed on whether additional interest rate increases would be needed. The consensus appeared to veer towards one more hike in the year 2023. However, there was no dispute on the fact that there was need for more policy tightening. The only change would be that instead of implementing hawkishness through rate hikes, it would be done through an elevated pause at higher levels. There is not much change in the seriousness about the inflation target of 2% in the long term.

   

• Even on the subject of one additional rate hike, the quorum was relatively mixed. While most members were in favour of one more rate hike, a section felt that rate hikes were done and dusted. Instead, they wanted the Fed to focus on the lag effect of 525 bps of rate hikes leaving a delayed imprint on the inflation reading. Here again, the emphasis was that the Fed should immediately shift to a long pause as compared to the uncertainty over more rate hikes. That may not happen for now.

   

• One term that appeared conspicuously in the Fed minutes and on which there was agreement, was the use of the term “proceed carefully.” The members of the FOMC agreed that after 525 bps of rate hike, the rates not only above the pre-COVID rates, but also well above the neutral rate. Any unwarranted hike in rates from here could have a magnifying impact on the GDP growth. The members of the FOMC, at the same time, also agreed that the undertone of the monetary policy should remain restrictive for some more time, till there was visible confidence that inflation was inexorably moving towards the 2% target.

   

• A clearer picture emerges when one looks at the dot plot of individual members of the FOMC (Federal Open Markes Committee). As per the dot-plot chart, nearly two-third of the members are in favour of one more rate hike before the end of this year. Rates are already at the highest level in the last 22 years, but then inflation has never been such a big problem in the last 43 years. So, unique problems do call from unique solutions.

   

• The generally consensus among the FOMC members was that the US economy had proven to be more resilient than expected in terms of GDP growth and in terms of job creation. The result is that most American consumers continued to spend, though officials worried about the impact from tighter credit conditions, less fiscal stimulus, and the resumption of student loan payments. Participants did express concerns about the individual balance sheets due to high inflation and declining savings. Also, there had been a great reliance on credit to finance expenditures.

   

• Even as the Fed minutes pertain to the September FOMC meet, one of the slightly disconcerting data points is the recent spike in PPI (producer price inflation), the equivalent of WPI inflation in India. PPI had risen 0.5% MOM and was well above what the street was expecting. It is a signal that higher producer inflation could translate eventually into higher consumer inflation. We have to wait and watch. For now, the consumer inflation for September is awaited on October 12, 2023; which his expected to be around 3.6%. That is jut about 10 bps lower than the August inflation reading.

   

• The broad theme of the  minutes was that the recent spike in inflation may be more of a cyclical exception. However, over the last 16 months, consumer inflation has fallen by close to 600 basis points and that has given the FOMC the reassurance needed to pause on rates in the September meeting. That is fair game considering that any rate hike takes time to transmit and only then it shows up its impact in the form of lower inflation. 

   

• One question remains. If the overall tone was not too hawkish, then why did yields rally so sharply in the benchmark US 10 year bonds? The reason had less to do with rate hike expectations and more to do with a general sell-off in bonds. In the last few months, there was heavy buying in bonds by various bond funds on the hope that these bond funds would gain from falling rates. However, with the rate cuts likely to be much slower than expected, the investors who had latched on to bonds were disappointed. There has been sustained dumping of bonds, which eventually led to a spike in yields. The context of the yield spike needs to be understood, although the topic did come up as part of the minutes of the Fed meeting.

To sum it up, it is not just concerns over GDP growth that is pushing the Fed to go slow on rate hikes and prefer a long pause. The more obvious impact is on the balance sheet of households and their levels of debt amidst rising inflation. Monetary tightness has started to hit consumer credit costs and individual consumers are the worst hit. That is the kind of casualty that the Fed really wants to avoid and that is apparent in the tone of the minutes.

How would RBI read the minutes of the FOMC

It may not be the end of rate hikes in the US, but that is fairly close. The current evidence is that the Fed would be done with another 25 bps hike and then the action will shift to longer pause and fewer rate cuts. That is good news for the RBI as it reduces its pressure to act in sync with the US central bank to avoid monetary divergence. However, India has its own share of problems, especially with consumer inflation at 7.44% in July and 6.83% in August 2023. The RBI is now a good 283 bps away from its inflation target of 4% and this has been entirely caused by food inflation. The impact of fuel inflation is yet to be fully factored in, so India has enough to worry about, even outside of what the Fed is doing.

RBI had effected its last rate hike in February and has kept rates on hold over the next 4 MPC meetings in April, June, August, and October 2023. CPI inflation is expected to come under the outer tolerance limit of 6% for September but we have to await the MOSPI data. While the RBI members in the MPC are still hawkish, the MPC overall is still ambivalent on whether it should hike rates. The Fed minutes will give the RBI the leeway to pause in December also. For now, the policy statement by the Fed gives some breathing space for the RBI. However, domestic inflation, rising global bond yields and a highly vulnerable Indian rupee remain the immediate preoccupying concerns for the RBI.