Fed minutes Oct-22 show members are bamboozled by inflation

13 Oct 2022 , 09:02 AM

Members of the FOMC are bamboozled by why inflation continues to remain elevated despite so much hawkishness shown by the Fed. For now, the reasoning of the FOMC members is that; for want of a better option they will continue to hike the Fed rates well through the end of 2022; and possibly the start of 2023.

In the last 3 meetings of the FOMC, the US Fed rates have been hiked by 75 bps on each of the occasions. Since March 2022, the Fed rates are up by a full 300 bps from the range of 0.00%-0.25% to the current rate of 3.00%-3.25%. But if one were to go by the language of the Fed and its member-speak, then another 75 bps hike looks likely in November, followed by a more subdued 50 bps hike in December 2022.

That would peg Fed rates in the range of 4.25%-4.50% by the of 2022. Clearly, most of the frontloading of rate hikes will happen in 2022 with a conservative terminal rate target of 4.6% and an aggressive terminal rate target of 5%. Whether all these efforts will actually curb inflation and whether the Fed can really prevent a hard landing remains the billion dollar question. The message from minutes is; get prepared for much higher rates.

Peak rate expectations inch closer to 5%

The CME Fedwatch table below captures the implied probabilities of rate hikes. Rates have already risen from the range of 0.00%-0.25% to the range of 3.00%-3.25% between March 2022 and September 2022. Interestingly, FOMC members do anticipate substantial front loading by the end of 2022. That will give the Fed time and leeway to undertake corrective action, if required. Here are the implied Fed rate scenarios over next 10 meetings.

Fed Meet	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550	550-575
Nov-22	18.0%	82.0%	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Dec-22	Nil	Nil	11.1%	57.4%	31.6%	Nil	Nil	Nil	Nil
Feb-23	Nil	Nil	0.7%	14.1%	55.7%	29.5%	Nil	Nil	Nil
Mar-23	Nil	Nil	0.6%	11.0%	45.9%	35.7%	7.0%	Nil	Nil
May-23	Nil	0.1%	1.6%	14.5%	44.8%	32.7%	6.2%	Nil	Nil
Jun-23	Nil	0.2%	2.7%	17.1%	43.8%	30.5%	5.7%	Nil	Nil
Jul-23	Nil	0.6%	5.2%	21.7%	41.5%	26.2%	4.7%	Nil	Nil
Sep-23	0.2%	1.5%	8.5%	25.7%	38.4%	21.9%	3.8%	Nil	Nil
Nov-23	0.7%	4.0%	14.7%	30.4%	32.5%	15.3%	2.4%	Nil	Nil
Dec-23	1.9%	7.3%	19.4%	30.8%	27.2%	11.6%	1.7%	Nil	Nil

Data source: CME Fedwatch

While the Fed has turned hawkish and is pegging higher terminal rates, here are some key takeaways from the CME Fedwatch numbers.

·         Between the Fed meet and the minutes, the probabilities of steeper rate hikes have gone up sharply. Estimates for terminal rates are up by more than 75 bps.

·         That means, with rates already in the range of 3.00%-3.25%, the markets are betting on rates to touch the range of 4.25% to 4.50% by the end of 2022.

·         That still hints at terminal rates of close to 5%, which is nearly 175 bps over and above the neutral rate as identified by the Fed.

·         As per the dot plot chart, rates would be substantially front loaded in 2022 with a best case rate hike of 50 bps in 2023 and a remote possibility of rate cuts in 2023.

·         Fed minutes have stuck to their eventual inflation target of 2% and are unlikely to relent on rate hikes till there is substantial progress towards that target.

With the latest IMF World Economic Report (WEO) pencilling tepid global growth rates in 2022 and 2023, the question is how long can the Fed continue to remain hawkish?

What we read in the Minutes of the FOMC meet

As we said in the very beginning, the Fed members are absolutely bamboozled by the structural and relentless nature of consumer inflation. Hence, the Fed members expect higher interest rates to remain in place until prices come down appreciably. This approximately pegs rate hikes at around 75 bps in November (the fourth such hike) and another rate hike of 50 bps in the December 2022 Fed meet.

Fed underlined that it was not only fighting inflation but also inflation expectations. Even if the Fed hawkishness may not immediately bring down inflation, the impact is likely to be seen through the reduction in inflation expectations. That is already evident. However, the inflation expectations are largely a function of the actions of the Fed and the immediate priority for the Fed is to bring down inflation without triggering a hard landing.

More than the inflation rate per se, the Fed members are also largely bamboozled by the relentless strength in labour with unemployment falling by another 20 bps from 3.7% to 3.5%. Interestingly, stock markets gathered steam on Wednesday after markets interpreted the ambivalence of the Fed as a signal that they may eventually react to market turbulence.

From the markets perspective, FOMC members are becoming increasingly concerned that the inflation battle may have significant impact on economic outlook for the US. The Fed does not rely on consumer inflation but on Price Consumption Expenditure (PCE), put out in the last week of each month. That has gone up from 4.9% last year to 6.2% in 2022.

The gist of the concerns expressed by the members of the FOMC is that the price fall was happening much slower than expected; largely on account of labour slack. After 2 quarters of negative GDP growth, the US GDP is expected to grow at just 0.2% in 2022 and a slightly improved 1.2% in 2023.

Four key takeaways from the Fed minutes

There are 4 important points we can infer from the Fed minutes for October 2022.

a)      Long term inflation continues to be driven by supply chain challenges and shortage of labour is resulting in higher manpower costs. That is also pushing up inflation in a big way; more like a Catch-22 situation.

b)      The second important takeaway is that the Fed officials do not expect rates to rise until inflation comes all the way down to 2%. Once the inflation starts its firm downward journey, the Fed may go slow on rate hikes.

c)      The rate hikes would be frontloaded to the tune of 95% in the year 2022, with some adjustments in 2023. However, the members have underlined that if growth becomes a priority, Fed may even be open to rate cuts. That is reflected in CME Fedwatch also.

d)      In terms of its terminal rate projections, it is likely to be 4.6% in a most likely scenario by early 2023 and a worst case scenario could be in the range of 5.00-5.25%.

What do these minutes mean for India?

The RBI already finds itself on the horns of a dilemma. If you look at the latest macro data, inflation is higher at 7.41% and IIP has contracted by -0.83%. In short, after 190 bps of rate hikes, the IIP growth has faltered, but the impact on inflation is hardly palpable. For the RBI, it has to quickly decide whether to run with the hares or hunt with the hounds.

The second quarter results are likely to show a 15% growth in top line but 3% de-growth in profits. Clearly, high inflation and low growth are forming a lethal combination and the decision has to come fast. Does the answer lie in an aggressively hawkish stance like the US and Europe; or does the answer like in a growth conducive approach like China has done? The truth, perhaps, lies somewhere in between. RBI has to now locate the middle point!