Fed minutes signal more inflation uncertainty in 2023

17 Aug 2023 , 11:09 AM

When the Federal Open Market Committee (FOMC) hiked the rates by 25 bps on July 26, 2023, it did not come as any major surprise. The rate hike has already been factored into the market calculations with CME Fedwatch having assigned a probability of over 90% to a 25 bps rate hike in July. However, the surprise was in the minutes of the meeting released on August 16, 2023. 

The statement had strong hawkish overtones, but more about that later. The reason the hawkishness was slightly disappointing was because it comes at a time when US consumer inflation has come down to 3.2% and the growth has remained stable. The hope was that after 525 bps of rate hike by the RBI, the undertone would have turned relatively benign. However, that was not the case. Unlike the June meeting and even the July meeting, when the Fed chair, Jerome Powell had hinted at a prolonged pause in rates, the minutes of the July meeting expressed rather deep fears about rising inflation and the need to hike rates further to prevent the monster of inflation from rising further. 

The good news is that the Fed is just about 120 bps away from its avowed inflation target of 2%, but then the Fed really does not want to take any chances on the inflation front. At least, that is what the language of the minutes of the Fed meeting appears to be indicating. The concerns are that food inflation and even fuel inflation could get slightly out of control, if the Fed does not intervene right now with a more hawkish approach.

CME Fedwatch has turned more hawkish post the minutes

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
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	86.5%	13.5%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	59.5%	36.3%	4.2%
Dec-23	Nil	Nil	Nil	Nil	Nil	Nil	5.0%	57.6%	33.6%	3.9%
Jan-24	Nil	Nil	Nil	Nil	Nil	1.1%	17.0%	52.1%	26.8%	3.0%
Mar-24	Nil	Nil	Nil	Nil	0.4%	7.3%	30.7%	42.2%	17.5%	1.8%
May-24	Nil	Nil	Nil	0.3%	5.3%	23.8%	38.9%	24.7%	6.4%	0.5%
Jun-24	Nil	Nil	0.1%	2.2%	12.4%	29.6%	33.5%	17.7%	4.2%	0.3%
Jul-24	Nil	0.1%	1.5%	8.8%	23.6%	32.1%	23.2%	8.9%	1.7%	0.1%
Sep-24	0.1%	1.1%	7.0%	19.9%	30.0%	25.5%	12.5%	3.5%	0.5%	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 almost looks like obvious, with an outside possibility of 2 more rate hikes. However, the CME Fedwatch is not factoring in peak rates at beyond 6% for now. Secondly, the downside in the form of rate cuts is, at best about 50 bps to 75 bps from current levels and anything beyond that looks unlikely, even in 2024. This is a clear outcome of the hawkish tone of inflation in the Fed minutes. 

What we read from the minutes of the Fed meet

The minutes of the July 26, 2023 Fed meeting was published by the FOMC on August 16, 2023. It had a clearly hawkish tone with expectations that inflation would trend higher. Already, Fed governor Michelle Bowman had indicated that it was soon to call a top on rates and that rates would trend higher to ensure that inflation stayed in control. Here are some of the key takeaways from the Fed minutes.

1. For the members of the FOMC, the biggest concern remains the pace of inflation and have indicated that to curb inflation, more rate hikes could be necessary in the future. That was, of course, subject to a drastic change in the current situation wherein the inflation starts falling rapidly. It may be recollected that after a pause in June, the Fed had hiked rates by 25 bps in July taking the rates to the range of 5.25% to 5.50%. it means that the Fed has now hiked rates a full 525 basis points since the time it started in March 2022.

    

2. The gist of the Fed minutes was that at 3.2% the consumer inflation was still a good 120 bps higher than the target of 2% that the Fed was eventually looking at. The problem is that the labour market is still tight and that means wages in the US economy would not come down in a hurry. Under these circumstances the probabilities were tilted towards a further spike in inflation from the current levels since consumer spending was likely to remain robust amidst rising wages. This, according to the FOMC members, actually called for more tightening, even if it means making a pre-emptive attempt. The current Fed rate in the range of 5.25% to 5.50% is already the highest level in last 22 years.

    

3. Like in any incisive debate, there were voices of dissent here too. Some members have believed that in the backdrop of such aggressive rate hikes, further rate hikes may be unnecessary. However, the minutes suggested caution. For now, the minutes have stuck to saying that future action would be guided by data flows, but the bias appears to be towards hiking the rates further if inflation did not get reined in. 

    

4. The minutes use the term “sufficiently restrictive” to describe how the approach of the Fed should be towards rate action. With actual consumer inflation and PCE inflation still about 100 bps to 120 bps away from the 2% target, some additional amount of hawkishness may be called for. The fact that rates have not gone below 3% after 525 bps of rate hikes, shows the amount of consumption resilience in the US economy. Unless that consumption resilience is curbed, inflation control may not really work.

    

5. One view is that the indications coming in are still ambivalent. There is agreement that inflation is still unacceptably high. However, members of the FOMC also stressed that there were enough indications that inflation was tapering in the US. The minutes reveal that even the non-voting members of the FOMC were in favour of increasing rates further if needed to curb inflation. There was also a strong feeling among a section of the FOMC members that the committee should have skipped a rate hike in July and wait for previous hikes to seep through. However, the vote was in favour of a hike in July.

    

6. However, participants were divided over the cumulative effects on the economy of past monetary policy tightening. In fact, the minutes noted that the economy had not been responding to the rate hikes as anticipated. In reality, the US economy was expected to slow and unemployment was expected to rise. However, even after 525 bps of rate hikes, that is not exactly visible. Also, now the staff economists have retracted an earlier forecast that troubles in the banking industry could lead to a mild recession this year.

    

7. Warning against too much of tightness, some members of the FOMC have highlighted the risks associated with a potential sharp decline in CRE (commercial real estate) valuations. This could adversely affect some banks and financial institutions like insurance companies, having a fairly high exposure to the CRE segment. This could tighten bank credit to consumers and this comes on top of the Moody’s downgrade of US banks, which happened after the policy announcement. 

    

8. Members discussed in details about the two side risks in policy. On the one side, there is the risk of loosening policy too quickly and risking higher inflation. On the other hand, there is the risk of tightening rates too much and sending the economy into contraction. Both are not a desirable scenario and hence the Fed also had the task of maintaining a very delicate balance in this case.

    

9. Members also emphasised that apart from the headline consumer inflation and headline PCE inflation, it was equally important to look at core inflation. In both cases, the core inflation is at least 100 bps higher than the headline inflation. Core inflation is more structural in nature and that is what the Fed is keen to control. That is the only guarantee that inflation will not spike in future, since food and fuel are very cyclical.

    

10. Finally, there are the lessons of the Volcker policy in 1970s, which his considered most akin to the current scenario. At that point, the central bankers had raised rates rapidly to combat double-digit inflation. However, they also backed off quickly when prices showed tentative signs of backing off. That is a situation best avoided and that is why the FOMC is being doubly careful.

The good news is that despite so much hawkishness, the growth has not been impacted. That gives more room to the Fed. Also, the Fed is simultaneously tapering its bond book and that is also a form of tightening. The net effect of all measures is what will matter in the final analysis; for the Fed and also for the global markets.

How should the RBI interpret the minutes of the Fed

It may be too early to call it the end of the rate hikes in the US, but the Fed is certainly very close to the top. That is the good news. However, India has its own problems to contend with, especially the consumer inflation spiking to 7.44% in July 2023. RBI may have to take a hawkish path, sooner rather than later. While the US economy is 120 bps away from its inflation target, India is now 344 bps away, even if one argues that this is purely due to cyclical food inflation. 

RBI had effected its last rate hike in February and has kept rates on hold over the next 3 MPC meetings in April, June, and August 2023. However, food inflation has spiked to above 11% in July due to erratic monsoons, followed by an erratic deluge. If July inflation was bad for India, August could even be worse. For the RBI, there is a lot of pressure to hike rates, at least by 25 bps. The question is not whether but when. Whether the RBI waits till October to hike rates or implements the rate hike before that, remains to be seen.