FOMC monetary policy report to Congress has hawkish hues

6 Mar 2023 , 09:21 AM

The Federal Reserve Act requires the Federal Reserve Board to submit the Monetary Policy Report semi-annually to the Senate Committee on Banking and to the House Committee on Financial Services. Typically, each year, this report gets submitted towards the end of February and then again towards the end of June. 

This Monetary Policy report submitted to the Congress makes the Federal Reserve Board accountable for its commitments and for the outcome of their actions. The Fed finds itself in a piquant situation at this point. For example, the inflation triggers are favourable in the sense that oil and commodity prices are falling and even food prices have tapered from the highs. However, the fall in inflation has not been as rapid as expected, and that is largely due to sticky core inflation. In addition, tight labour market is also making transmission of higher rates into lower inflation difficult. That is because, higher wages among the consuming population are offsetting the higher cost of funds brought about by Fed hawkishness. This is the background in which the report was submitted by FRB.

Monetary policy report broadly covers 3 areas viz. (1) progress on interest rates (2) progress on reducing size of Fed balance sheet and (3) Outlook for rates and inflation in future.

Federal Fund rate hikes have continued

The hawkish monetary policy of the Fed just about completes one year in March 2023. Between March 2022 and February 2023, the Fed has increased the interest rates from the range of 0.00%-0.25% to the range of 4.50%-4.75%. This 450 bps rate hike is not only the fastest pace of rate hike in just 11 months, but also it is the highest level of Fed Funds rate since the year 2007 (just prior to the global financial crisis). Between June 2022 and November 2022, the Fed hiked rates by 75 bps on 4 occasions. However, the rate hikes were toned down to 50 bps in December 2022 and further to 25 bps in February 2023.

However, the minutes of the February 2023 FOMC (Federal Open Markets Committee) clearly indicate a shift towards a more hawkish policy. The Fed has not only indicated the likelihood of another 50 bps rate hike in the forthcoming meeting, but has also hinted at a higher terminal rate of interest veering towards the range of 5.50% to 5.75% and even going up to 6% in a worst-case scenario. Clearly, Fed thinking on the trajectory of rates appears to have undergone a shift in 2023; and we shall see more of this aspect later.

Fed reduces its holdings consistently

When the Fed started the hawkish approach in March 2022, it was clear that it would combine rate hikes with winding down the assets on the Fed balance sheet. The idea was to amplify the impact of rate hikes with liquidity tightening so that monetary policy is more effective. Between June 2022 and February 2023, there has been a perceptible shift in the Fed balance sheet as the shrinking has continued at around $60 billion per month. That may sound paltry in the light of the $9 trillion Fed balance sheet last year, but it has surely helped balance inflation and liquidity in a meaningful way.

Securities Held by Fed  ($ billion)	February 22,  2023	June 15,  2022	Change in  $ bn	Change in  % terms
Treasury securities	5,364	5,763	-399	-6.92%
Agency debt and MBS	2,623	2,730	-107	-3.92%
Net unamortized premiums	308	336	-28	-8.33%
PPPLF	11	19	-8	-42.11%
Other loans and lending	34	38	-4	-10.53%
Other assets	41	47	-6	-12.77%
Total assets	8,382	8,932	-550	-6.16%

Data Source: US Federal Reserve

First a quick background to the building of the Fed balance sheet. During the global financial crisis of 2008, the Fed and other central banks around the world embarked upon monetary easing in a big way. The easiest way was to infuse liquidity in the market by buying treasury securities and mortgage debt. However, while this did infuse liquidity, it also expanded the Fed balance sheet. Between 2008 and 2013, the Fed balance sheet had expanded from $2 billion to $4 billion. However, since 2016, the Fed had been consistently pruning its balance sheet size; till the COVID pandemic changed all that.

When the pandemic struck in late 2019 and early 2020, the Fed had to once again resort to liquidity infusion to ensure that there was sufficient liquidity in the market so that growth did not suffer. However, this surfeit of liquidity had two implications. Firstly, it once again expanded the Fed balance sheet (this time to a whopping $9 trillion). Secondly, with too much liquidity sloshing around in the economy, the inflation started to go up sharply. That is when the Fed decided to amplify the rate hikes with balance sheet unwinding to address the challenge of persistently rising inflation. As can be seen from the table above, the Fed assets have shrunk by $550 billion (6.16%) between June 2022 and February 2023.

FOMC outlook on key economic indicators

The third and last part of the Monetary Policy report submitted by the FRB to the Congress is about the projections that the Federal Reserve has made for key macroeconomic parameters. The table below captures the Fed projections of key macros for the next 3 years, and the long-term sustainable rate.

Variable	2022 (%)	2023 (%)	2024 (%)	2025 (%)	Long Run (%)
Change in real GDP	0.5	0.5	1.6	1.8	1.8
September projection	0.2	1.2	1.7	1.8	1.8
Unemployment rate	3.7	4.6	4.6	4.5	4.0
September projection	3.8	4.4	4.4	4.3	4.0
PCE inflation	5.6	3.1	2.5	2.1	2.0
September projection	5.4	2.8	2.3	2.0	2.0
Core PCE inflation	4.8	3.5	2.5	2.1	N.A.
September projection	4.5	3.1	2.3	2.1	N.A.
Federal funds rate	4.4	5.1	4.1	3.1	2.5
September projection	4.4	4.6	3.9	2.9	2.5

Data Source: US Federal Reserve

The above table has two data points of note. Firstly, it shows the projected values of various variables for the next 3 years and the long run sustainable rate. In addition, the high frequency trends are also evaluated since each variable is also compared with the September 2022 projection. Here are some of the key takeaways.

1. Real GDP growth is expected to stabilize at around the long-term rate of 1.8% by 2025 and sustain after that. However, on a short-term basis, the GDP growth for 2023 has been sharply scaled down from 1.2% to 0.5%, showing the impact of a likely slowdown.

    

2. Unemployment is expected to stabilize at around 4% in the long run. In the short run, the unemployment has been projected to rise in 2023 from 4.4% to 4.6%. However, this looks far-fetched considering that unemployment is at a 50-year low of 3.4%

    

3. The Fed has upped its PCE inflation projections and the core PCE inflation projections sharply for 2023 as compared to the projection in September 2022. However, Fed also projects the long term PCE inflation target of 2% by the year 2025.

    

4. Finally, on the Fed rates, there is a lot more front-loading as the Fed Fund rate projection for 2023 is raised by 50 bps to 5.1% compared to 4.6% made in September 2022. Also, the long run fed rate has been pegged at 2.5%.

To sum it up, there are hawkish hues to the Fed Monetary Policy Report. The first half of 2023 should give a clearer picture of the monetary policy trajectory.