US Fed Chairman says interest rate hike unlikely

2 May 2024 , 03:55 PM

FED MAY POLICY RAISES MAJOR CONCERNS OVER INFLATION

The latest Fed policy statement was announced late on May 01, 2024 after a month of persistent inflation surprises. Firstly, there was the consumer inflation in the US announced in the middle of April. That came in 30 bps higher at 3.5%. Then the March PCE inflation announced towards the end of April also came in 20 bps higher at 2.7%. That took the PCE inflation 70 bps away from the 2% target, and also marked the saturation of core inflation gains. Above all, first advance estimate of March quarter GDP growth in the US came in sharply lower at 1.6%, compared to 3.4% and 4.9% in the two sequential quarters. What was worrisome was that this sharp fall in real GDP was caused by a spike in inflation.

OOPS! NO CHANGE IN 3 RATE CUTS PROMISE

What actually surprised the street was that the Fed did not hint at any change in its “minimum 3 rate cuts” stance expressed in the March 2024 policy statement. At that point, inflation was already a concern, but Jerome Powell had hinted that it would anyways undertake 3 rate cuts in 2024. With the street expecting the first rate cut to only happen in September or afterwards, the Fed chair was expected to retract that statement and modify it to just 1 rate cut in 2024. However, that was not the case, so we can now expect such a clarification only in the next policy statement in mid-June. However, the Fed has said in no uncertain terms that inflation was not going away in a hurry. That means; the “higher for longer” approach to rates could continue for now and we may see just about 1 rate cut in 2024. For an official clarification, we have to wait till June.

KEY SIGNALS WE GATHERED FROM MAY 2024 FED STATEMENT

The tone of the Fed in the May  policy statement, was largely similar to the tone in the March policy statement. Fed was unwilling to commit to any time table on rate cuts till there was absolute clarity on the inflation front. Fed is still awaiting confirmation that inflation is inexorably moving towards 2%. As the Fed policy extended its “higher for longer” policy for the tenth month, we gathered these 6 signals from the Fed policy statement.

• Inflation has eased substantially since the peak of 2022, when it had gotten close to 9%. From that point, there has been a lot of progress in taming inflation. However, the Fed statement was explicit that there is still a long way to go and the 2% target was not something they could see in the horizon. Till then, any rate cuts were almost unlikely.
• Consumer demand continues to remain relatively high, despite the tightness that the Fed policy and the mini-banking crisis imposed on the US consumers. This could be largely attributed to the massive liquidity infusion by the Fed in the aftermath of the pandemic; and the lag effects were visible in the form of robust consumer demand.
• One of the factors that had impeded the fall in inflation was a tight labour market as wages remained high and offset most of the monetary tightness imposed. The progress in recent months has been that the nominal wages have come down, but the labour market continues to remain undersupplied. That could keep pressure on inflation.
• Monetary policy actions of the Fed would continue to be guided by the dual mandate of price stability and a strong labour market. As long as the Fed has to tread that fine line, monetary policy is likely to remain ambivalent, at least on paper. Rate cuts would commence only if there was clear indication of inflation trending towards the 2% mark.
• Fed officials have confirmed that reducing policy rates too soon, or too much or too little have their own risks. Hence, the Fed would be able to take a view only on a meeting by meeting basis. This largely puts the 3-rate cut promise in 2024 on hold, although that has not been explicitly ruled out. Restrictive policy impact is showing on labour market.
• On the balance sheet unwinding program, the Fed announced a clear slowing down after the balance sheet reported a sharp tapering in the last 1 year to $7.40 Trillion. The Fed bond value unwind is being reduced from $60 Billion a month to $25 Billion a month, and this would ensure that liquidity conditions remained smooth in money markets.

To sum it up, the markets had three reasons to cheer. Firstly, the Fed has not ruled out 3 rate cuts in 2024; although it is increasingly looking unlikely. Secondly, the Fed also hinted that the rate hikes were not on the agenda, except from some random debates. Lastly, the Fed has given an important message on the slowing of quantitative tightening, indicating that it would not allow its monetary stance to impact the money market liquidity.

CME FEDWATCH ALIGNED TO 3 RATE CUTS IN CALENDAR 2024

One way to look at the Fed outlook from a market perspective is to evaluate the CME Fedwatch. This table below captures the probabilities of various rate levels after each Fed meet over next 1 year, from June 2024 to July 2025. One big question after the minutes is; whether the CME Fedwatch is still reflective of the real story?

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Jun-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	9.1%	90.9%
Jul-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	1.9%	26.0%	72.1%
Sep-24	Nil	Nil	Nil	Nil	Nil	Nil	0.7%	10.6%	42.6%	46.2%
Nov-24	Nil	Nil	Nil	Nil	Nil	0.2%	3.3%	19.0%	43.5%	34.0%
Dec-24	Nil	Nil	Nil	Nil	0.1%	1.5%	10.1%	29.7%	39.4%	19.2%
Jan-25	Nil	Nil	Nil	Nil	0.5%	4.2%	16.4%	32.9%	33.0%	12.9%
Mar-25	Nil	Nil	Nil	0.2%	2.1%	9.5%	23.5%	32.9%	24.3%	7.4%
Apr-25	Nil	Nil	0.1%	0.8%	4.3%	13.7%	26.3%	30.4%	19.3%	5.2%
Jun-25	Nil	Nil	0.4%	2.3%	8.4%	19.2%	28.1%	25.5%	13.1%	2.9%
Jul-25	Nil	0.2%	1.1%	4.5%	12.2%	22.3%	27.1%	21.1%	9.5%	1.9%

Data source: CME Fedwatch

The CME Fedwatch has been broken up into two milestones; end of 2024 and the middle of 2025. These are market driven implied probabilities based on the Fed futures trading, so they are dynamic. However, after each major event (like the recent Fed statement), the probabilities in the CME Fedwatch undergo a shift based on how the market looks at the likelihood of rate cuts / rate hikes in the coming 12 months. One trend visible after the Fed statement on May 01, 2024 is that there has been a clear shift in probabilities towards the right side of the distribution. That means, the market has been gradually turning more hawkish in its view and the latest policy statement has accentuated that trend.

So, what exactly is the CME Fedwatch indicating. Irrespective of what the Fed says or does not say, the CME Fedwatch remains a strong market driven indicator of rate cut expectations. Let us look at the first milestone of December 2024. The CME Fedwatch has assigned a probability of 60% to just one rate cut in 2024. The surprising part is that the CME Fedwatch is assigning a good 20% probability to no rate cuts till the end of 2024. Will the situation change in 2025? That is still a long time away and a lot of data points will flow in the intervening period. However, by July 2025, the CME Fedwatch is expecting 3 rate cuts, which means 2 more rate cuts 2025. However, this would be entirely dependent on the data flows between now and the middle of 2025.

FED THEME – CERTAINLY HIGHER FOR LONGER

The one thing that comes out explicitly from the Fed statement is that the Fed continues to remain ambivalent on rate cut and is likely to remain ambivalent in the near future on the rate cuts front. The Fed has tasted the downsides of being too late on rate cuts and does not want to second guess the macroeconomy by being too early on rate cuts. It is this caution that is driving the Fed approach. Here is what we read in the Fed May 2024 statement.

• The Fed held its ground on interest rates, and ruled out rate cuts till the Fed was battling the recent spike in inflation. It may be recollected that the US Fed has now kept its benchmark short-term borrowing rate in a range of 5.25%-5.50% since July 2023. Incidentally, this is the highest level in the last 20 years.
• One big news for the markets is that the Fed would be reducing its tapering of the bond book. The bond book has already been tapered by nearly $1.7 Trillion from a peak of $9.1 Trillion to the current level of $7.4 Trillion. The annual bond book tapering is being reduced from $720 Billion to $300 Billion. This move is likely to keep money market liquidity robust amidst a tightening rate scenario.
• Till the previous policy, the Fed statement on its progress on inflation control was caution. It had earlier said that the Fed was “making progress” in its dual mandate of price stability and full employment. In the May 2024 policy, the Fed statement shows a lot more confidence as it says that the Fed had “made meaningful progress in bringing about a better balance between ensuring stability and full employment.”
• The equity markets were enthused by the Fed statement that, “the next move by the Fed will not be a rate hike.” That lays the limits for the Fed action. The worst-case scenario would be higher for longer; and the best case scenario would be a couple of rate cuts in the next few months. Either ways, this rules out the equity market worries about a possible spike in rates, leading to a spike in bond yields.
• Jerome Powell specifically pointed out that, consumers have continued to spend, running up credit indebtedness and decreasing savings levels amidst stubbornly high prices. This has had an impact on the stability of household finances. The Fed has been obsessed about inflation for two reasons. Firstly, it hits the most vulnerable sections the most. Secondly, it impacts inflation expectations and raises question over the credibility of Fed action and its ability to ensure price stability.
• There have been few things about the inflation reading that the Fed has found disconcerting. For starters, the bulk of the swing inflation in the recent months is coming from energy prices. That is a direct fallout of the ongoing geopolitical crisis in the Middle East and West Asia. The US has little control over this factor. Secondly, much of the tapering in inflation happened in core inflation as global supply chain constraints got remedied. That appears to have saturated and additional gains from falling core inflation may be limited for the Fed. In short, the last mile just got tougher for the Fed.

Interestingly, the banks in the US are paying higher rates to attract deposits and that means rate cuts would, anyways, take longer to reflect on consumer rates.

HOW WILL RBI INTERPRET THE MAY 2024 FED STATEMENT

RBI implemented its last rate hike in February 2023 and kept status quo in the next 7 meetings till April 2024. For the RBI, the real problem is food inflation which is still elevated. Also, the current heat wave conditions will not permit food inflation to come down rapidly. Oil inflation may look OK on a yoy basis, but the high frequency pressure is evident; and that is not good news for consumer inflation. For now, RBI will prefer to wait and watch till the election outcome is known on June 04, 2024 and the full budget is approved in July 2024. While the RBI has already ruled out rate hikes due to its disruptive implications, rate cuts will be more calibrated. If the language of the April RBI monetary policy is anything to go by, rate cuts are ruled out before the last quarter of 2024. That syncs with the Fed timing too.