Fed persists with 25 bps hike, propels 500 bps since March 2022

4 May 2023 , 09:58 AM

The Fed move can be seen as rather surprising in the light of American banks facing a severe crisis. The likes of Silicon Valley Bank, Signature Bank and First Republic Bank have already gone bust and there are more on the anvil. However, the response to this crisis had come from the Fed in March itself; that monetary policy would not be influenced by the banking crisis. The Fed seems to be wedded to the idea of cutting down inflation at any cost.

With the latest 25 bps rate hike in May 2023, the rates have touched the range of 5.00% to 5.25%. That is a full 500 basis points higher than where the rate hike story started in March 2022, and that is a lot of hawkishness. Inflation has been certainly coming down, but the Fed is not yet happy. In fact, the hint from the Fed chair, Jerome Powell, is that the Fed is not done with rate hikes and there could be more on the anvil. The rate action of the Fed was surprising, not only because of the banking crisis, but also because of the first advance estimate of GDP for Q1CY23 slowing to 1.1%.

Market view on rates diverges from Fed talk

CME Fedwatch reflects implied probabilities of future rate hikes based on Fed futures pricing. It captures probabilities of rate levels after each Fed meet over 1 year.

Fed Meet	275-300	300-325	325-350	350-375	375-400	400-425	425-450	450- 475	475-500	500-525
Jun-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	9.0%	91.0%
Jul-23	Nil	Nil	Nil	Nil	Nil	Nil	Nil	4.7%	51.7%	43.6%
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	3.5%	37.6%	46.0%	13.1%
Nov-23	Nil	Nil	Nil	Nil	Nil	2.9%	33.7%	45.1%	16.8%	1.5%
Dec-23	Nil	Nil	Nil	Nil	2.9%	33.4%	45.0%	17.1%	1.6%	Nil
Jan-24	Nil	Nil	0.1%	3.9%	33.8%	44.1%	16.6%	1.6%	Nil	Nil
Mar-24	Nil	0.4%	6.0%	34.5%	42.1%	15.6%	1.5%	Nil	Nil	Nil
May-24	2.1%	14.0%	36.3%	34.9%	11.6%	1.0%	Nil	Nil	Nil	Nil
Jun-24	10.4%	37.2%	35.5%	21.2%	5.4%	0.4%	Nil	Nil	Nil	Nil

Data source: CME Fedwatch

Like we saw after the March Fed meeting, there appears to be a distinct divergence between what the Fed has been saying and what the markets are interpreting. The divergence first showed up in March and has again manifested quite sharply in May 2023. Here is why the divergence is interesting from a market perspective.

• The markets had been expecting that the Fed would go slow on rate hikes considering the banking crisis and the slowing GDP growth. However, the Fed belied both the expectations and stuck to its hawkish path. 

   

• The Fed and the markets have diverged on two fronts. Firstly, there is the divergence on the peak rate. Powell has indicated in his post-policy conference that the Fed was not done with rate hikes yet. However, based on the Fed Futures probabilities, it appears the rates have already peaked at 5.00%-5.25%.

   

• The other area of diveregence is on future rate cuts. Powell had stated in March that there would be no rate cuts in year 2023. However, Fed futures are factoring in a rate  cut of 100 bps by the end of 2023 and a full 200 bps by middle of 2024. Of course, even the Fed had hinted at likely rate cuts in 2024.

For now, it looks like the Fed is not perturbed by the banking crisis or the slowing US economy and prefers to stick to its hawkish stance. However, there is always the risk of monetary desperation setting in an interconnected market. We have to wait and watch!

Interesting takeaways from the May 2023 Fed statement

As the US approaches closer to its terminal rate and farther from its neutral rate of interest, there are some interesting policy challenges. For now, Powell continues to maintain a brave face of monetary policy insularity. However, that is hardly the case in reality. Here is why.

• The latest 25 bps rate hike represented the 10th hike of the current cycle, which started in March 2022. The current Fed rate in the range of 5.00% to 5.25% is the highest level since 2007; just before the global financial crisis. Despite the conflicting macro situation, Powell continued to maintain that more rate hikes were possible. This is despite the Fed statement hinting at a pause.

   

• In the May 2023 meeting, Powell underlined that there would be no further guidance on rates, but instead the focus would entirely be on data flows. Key variables like consumer inflation, PCE inflation, unemployment rates and GDP growth would influence the Fed decision in the future. The message appears to be that Fed may have been late in starting the rate hikes, but they don’t want to reverse their stance too early. 

   

• In his post policy conference, Powell expressed fervent optimism that an economic recession can be avoided. A hard landing is not only a warning coming from the economists, but even recent GDP data, consumer spending data and an inverted yield curve; all  of which point to an economic recession. Powell has pointed to the durable strength of the US job market. Powell sees the excess demand in the labor market as a signal that the economy was robust. Also, the last few months had shown a fall in job openings without a simultaneous increase in unemployment rate. That is a divergence from the historical pattern, which is why Powell believes this time would be different. But, as Sir John Templeton had said, “The 4 most dangerous words in economics are This Time Its Different”. For now, Powell has underlined that the probability of the US avoiding a recession was more than having a recession.

   

• Powell appears to have closed doors to any rate cut in 2023, although he does not rule it out in 2024. On the other hand, the markets are factoring in 100 bps rate cut by December 2023 and 200 bps rate cut by mid-2024. Powell’s argument is that inflation would only come down gradually, which obviates the need for rate cuts in 2023. He also thinks the current policy is sufficiently restrictive to reverse inflation.

   

• Powell has an interesting take on the banking crisis. He believes that the banking turmoil in March and April had automatically resulted in less availability of credit in the US economy. This is only likely to supplement the Fed’s tightening job. Which could mean that the Fed may not have to raise rates much higher from current levels. According to Powell, the rates may not be at the top, but is very close to the top. That is the reason, Powell does not see any reason to announced a pause.

For now, the Fed is more worried about inflation, than about a recession. But, the divergence in interpretation with markets is rather interesting.

What does this Fed policy statement mean for India?

Interestingly, the RBI had opted for a status quo on repo rates in the April 2023 policy, despite the Fed hawkishness. With the Fed continuing to remain hawkish, the challenges for the RBI could become more acute. On the one hand, US bonds continue to be attractive and that is likely to draw FPI flows in the short to medium term. On the other hand, the RBI also has to contend with rising cost of funds and falling solvency ratio for Indian companies. As the Fed continues its hawkish stance, these choices just get tougher for the RBI. We need to just await the Fed minutes for greater clarity.