June 2023 Fed minutes give clear indication of more rate hikes

6 Jul 2023 , 07:06 AM

However, the language of the Fed statement was still too hawkish for the markets to feel comfortable. In subsequent days, Powell has underlined at various forums that the Fed was not done with rate hikes and markets should expect between 2 and 3 additional rate hikes of 25 bps each. When the minutes of the FOMC were announced by the Fed, exactly 21 days after the Fed meet, the message is quite unequivocal. Fed has only paused in June and it will resume rate hikes from July. After all, the Fed target inflation of 2% is still about 200 bps away. Since March 2022, the US Federal Reserve had hiked rates 10 times taking the rate of interest from the range of 0.00%-0.25% to the current range of 5.00%-5.25%. However, the FOMC minutes have made it clear that June pause was not a change in the Fed trajectory.

At the Fed meet, if you look at the individual dot plot charts of the 18 members, only 2 members are agreeable to restrict the Fed trajectory to just one rate hike. 12 out of the 18 FOMC members have expressed the need for two or more rate hikes. In short, the undertone of the FOMC members still continues to be very hawkish. However, there is an increasing consensus among the members that the Fed should give more time to the markets to adjust to the data flows. That may induce the Fed to pause occasionally rather than front end the remaining rate hikes.

Fed underscores more rate hikes on the cards

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
Jul-23	Nil	Nil	Nil	Nil	Nil	Nil	11.3%	88.7%	Nil	Nil
Sep-23	Nil	Nil	Nil	Nil	Nil	Nil	9.1%	73.2%	17.7%	Nil
Nov-23	Nil	Nil	Nil	Nil	Nil	Nil	6.9%	57.8%	31.1%	4.3%
Dec-23	Nil	Nil	Nil	Nil	Nil	0.9%	13.6%	54.3%	27.5%	3.7%
Jan-24	Nil	Nil	Nil	Nil	0.3%	4.6%	25.3%	46.6%	20.6%	2.6%
Mar-24	Nil	Nil	Nil	0.1%	2.4%	13.6%	33.5%	35.1%	13.6%	1.7%
May-24	Nil	Nil	0.1%	1.8%	11.0%	28.8%	34.7%	18.7%	4.5%	0.4%
Jun-24	Nil	Nil	0.8%	5.4%	18.3%	3.6%	28.3%	12.7%	2.7%	0.2%
Jul-24	Nil	0.6%	4.2%	14.5%	27.4%	29.0%	17.4%	5.8%	1.0%	0.1%

Data source: CME Fedwatch

While the Fed statement gives the regulatory and policy perspective, the CME Fedwatch gives the market view. There has been an interesting shift in the last couple of months. Around April and May 2023, the market view had strongly diverged from the Fed. Even as the Fed had been insisting on no rate cuts in 2023, the markets had actually factored in 100 bps rate cut in 2023 and up to 200 bps rate cut by mid-2024. In the last couple of months, the markets have veered sharply towards the Fed point of view.

The Federal Reserve takes its communication quite seriously and normally sticks to its word since it is committed to managing inflation expectations. The markets are now mirroring the Fed point of view now. In fact, in the last 2 months, the Fed probabilities have shifted right towards greater hawkishness in the markets too. In fact, now 2 more rate hikes are almost axiomatic and a third rate hike is also looking likely, taking the rates to a possible terminal level of 5.75% to 6.00% by the end of calendar year 2023.

What the minutes explained about the Fed statement 

The minutes of the FOMC are largely an explanation of the stance of the committee and how the view was arrived at. Hence the views are a lot richer in content. Here is what we read from the minutes of the June FOMC meeting.

• The FOMC members are quite clear that further policy tightening was not only likely, but also essential to bring inflation fully under control. One thing is that the rate hikes would be more calibrating and even, at times, halting. However, the direction of rates for now is trending higher.

   

• The pause in the June Fed policy was purely from the point of view of allowing them more time to assess the economy’s progress toward the goals of maximum employment and price stability. The FOMC minutes also hinted that this kind of an approach could also characterize the coming months as front-ending was not required now.

   

• However, members admitted that the persistent tightening by the Fed had its repercussions on the Indian economy. For instance, the Indian economy was facing tighter credit conditions for households and businesses. This could weigh on economic growth although in the Q1 final estimates, that kind of pressure was not visible.

   

• The Fed also underlined in its minutes that the rates should be seen in terms of its cumulative impact rather than its one-off impact. 10 consecutive rate hikes are quite a lot and it needs some time for the market to adjust to the new order. Also, rate hikes impact inflation with a lag, rather than having an immediate impact.

   

• There were some interesting member specific patterns. For example, after the pause in June policy, only 2 out of the 18 members expected that at least one hike would be appropriate this year, while 12 members expected two or more. In fact, the members favouring an immediate 25 bps rate hike had increased due to tight labour conditions.

   

• The general consensus, even among the hawks, was that the pace of hikes should abate in future. While slowing the pace of rate hikes was justified in the backdrop of rapid hikes in the last 15 months, giving up on hawkishness was not advisable till the time inflation came decisively lower.

   

• The mood of the members of the FOMC was best captured by Jerome Powell in his statement to the Congress earlier this month, “The central banks still have a long way to go to bring inflation back to the Fed’s 2% goal.” All 18 members saw rates either at current levels or higher by the end of the calendar year 2023. Rate cuts were ruled out.

   

• On the subject of a sharp fall in the PCE inflation to 3.8% in May 2023, the Fed underscored that what really mattered from a policy perspective was the core PCE inflation, which had fallen by just about 10 bps and was still at an elevated 4.6%. Inflation reduction was visible in food and fuel; both of which are cyclical in nature.

The labour market has been showing signs of loosening, but the unemployment rate is still pretty close to full employment in the US economy.

How should the RBI read the minutes of the FOMC?

The RBI had announced a pause in rates in April 2023, when the Fed had stayed hawkish. The RBI has repeated that action in June also. Back in April 2023, the RBI decision did look like a big risk as it could have resulted in monetary divergence. In retrospect, the decision was corrected. On the one hand, it placated the industry bodies, but also allowed the cumulative effect of the rate hikes over the last one year to gradually sink into inflation.

RBI can take solace from the fact that the inflation target of 4% in India is now just about 25 bps away. On the other hand, the US consumer inflation still has to traverse another 200 bps to get to its target of 2% inflation. However, RBI cannot entirely ignore the hawkish tone of the Fed as it has larger implications for currency value and portfolio flows. At a time when India has got $11 billion into equities from FPIs in May and June, it would be keen to ensure that this momentum is not lost. That is likely to be disrupted if the rate divergence increases. That is something the RBI would have to be cautious about.