FOMC minutes hint at front-ending rate hikes, with flexibility

27 May 2022 , 04:33 PM

The message of the FOMC minutes announced by the US Federal Reserve on 26th May was clear. “Monetary policy in the US may have to move beyond the Neutral zone and into Restrictive territory”. That means; Fed could risk some impact on growth just to ensure that rampant consumer inflation at above 8% is quickly brought under control.

However, one cannot miss out the tone of pragmatism in the minutes of the Fed. Most of the members are now of the view that over the next couple of meetings, 50 bps hikes may be inevitable to send the right message about the earnestness of the Fed. However, Fed is veering towards reviewing its stand in the last quarter of 2022, based on the high frequency impact on growth levers. First the Fedwatch!

CME Fedwatch hints at 2.75%-3.00% in 2022, but a pause after that

CME Fedwatch captures probability of rate hikes at future meetings based on the yields implied in Fed Futures trading. Here are implied Fed rate scenarios over next 10 meetings.

Fed Meet	100-125	125-150	150-175	175-200	200-225	225-250	250-275	275-300	300-325	325-350	350-375
Jun-22	Nil	93.7%	6.3%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Jul-22	Nil	Nil	4.2%	89.4%	6.4%	Nil	Nil	Nil	Nil	Nil	Nil
Sep-22	Nil	Nil	Nil	2.7%	58.7%	36.3%	2.3%	Nil	Nil	Nil	Nil
Nov-22	Nil	Nil	Nil	0.1%	4.0%	58.2%	35.5%	2.3%	Nil	Nil	Nil
Dec-22	Nil	Nil	Nil	Nil	0.2%	6.5%	57.2%	34%	2.1%	Nil	Nil
Feb-23	Nil	Nil	Nil	Nil	0.1%	3.6%	33.3%	44.9%	17.1%	1.0%	Nil
Mar-23	Nil	Nil	Nil	Nil	0.1%	1.8%	18.2%	39.0%	31.3%	9.2%	0.5%
May-23	Nil	Nil	Nil	Nil	0.1%	1.6%	16.5%	36.9%	32.0%	11.5%	1.5%
Jun-23	Nil	Nil	Nil	Nil	0.1%	1.6%	15.8%	35.9%	32.3%	12.5%	1.9%
Jul-23	Nil	Nil	Nil	Nil	0.2%	3.0%	17.8%	35.5%	30.4%	11.4%	1.8%

Data source: CME Fedwatch

Generally probability in the range of 25% to 30% is a strong indication of affirmative action. There are some distinct shifts since the Fed statement on May 04th 2022.

• If you look at the first part up to the range of 275-300 bps, the probabilities are getting more intense that rates should touch 3.00% by December 2022.
• However, post December, the Fedwatch is just about pencilling in about 25 bps rate hike in 2023, implying rates to peak out around 3.25%.
• The subtle shift has been led by Fed members demanding that Fed hike rates aggressively but also do a base-zero review of GDP growth impact in Q4.
• The big shift in the Fed thinking seems to be the flexibility visible in the Fed minutes with the R-warning (recession) from economists getting increasingly strident.

In short, Fed is now open to rethink its focus on inflation control towards the last quarter of 2022. However, for next 3 FOMC meetings, focus will be on aggressive inflation control.

Key takeaways from the FOMC Minutes (May 2022)

A quick reading of the minutes leaves us with key inferences about the trajectory of rates and liquidity in the US, as the Fed fights highest inflation in 40-years.

1. The Fed minutes have not minced words. There would be 50 bps rate hikes in June, July and, possibly, September. The target for 2022 is to take Fed rates to the range of 275-300 bps from the current 75-100 bps.
2. An interesting usage is the move from “Neutral to Restrictive”. It is not just enough to revert the COVID largesse. Fed will focus on making the cost of money prohibitive and tighten liquidity to discourage consumption-driven inflation.
3. In a rather significant shift, Jerome Powell directly addressed the American public over inflation concerns. The theme was not just to manage inflation but to also manage the inflation expectations of the people.
4. It is clear from the minutes that members see 2.50% to 2.75% as neutral, so year-end rates will go beyond that. However, the incentive for the markets is a commitment from the Fed that it would be flexible on rates; should growth falter.
5. As an aside, the word “Inflation” appeared more than 60 times in the minutes. More than anything, it underlines 2 things. Firstly, inflation is not transitory and secondly the Fed is obsessed with controlling inflation.

The gist of the minutes was best summed up by Powell when he said that Fed needs “clear, convincing and conclusive” evidence that inflation had dipped or was headed to the 2% mark. That would be the time for reviewing their hawkish stance.

What the FOMC members highlighted

FOMC minutes is about what the 12 members of the FOMC highlight in terms of specialist insights. Here are some interesting insights.

• The twelve members of the FOMC are unanimous about 50 bps rate hikes in the June and July FOMC meets. However, Powell signalled there could be some pain as the Fed action raises unemployment from the current 3.6%.
• FOMC members concurred that several months of sustained fall in inflation would be essential to conclude that inflation had peaked. Members have agreed to sustain the pace of rate hikes if inflation did not moderate by September 2022.
• One important discussion point was that Fed does not use consumer inflation; but uses personal consumption expenditure (PCE) inflation. That is estimated to have fallen from 5.2% in March 2022 to 4.8% in April 2022. We have to await PCE data on 27th May.
• Even Powell admitted that first signs of cooling down are visible. Housing market mellowed due to higher mortgage rates while equities have fallen 20% to 25%; with NASDAQ losing 30% from the peak.
• Fed members were silent about the stopping point for rate hikes, which will be subject to interim review in September. Recession fears are still lurking, but for now it appears to be more of a theoretical possibility.

Powell highlighted the need to manage inflation expectations since persistently high inflation leads to a spike in inflation expectations. That remains elusive for now.

What are the takeaways for India from the May-22 FOMC minutes

On the positive side, India has been proactive in its inflation battle. It has not only hiked rates in May but amplified it with CRR hike. In addition, it has also initiated fiscal measures like import duty cuts, export duty levies and export quotas to address the critical supply chain issues. That should largely offset Fed hawkishness.

Indian markets will take heart from the tone of flexibility that Fed is willing to review its hawkish stand in the last quarter. That means; India does not have to overtly worry about monetary divergence. However, that does put Indian markets in a tentative zone for a better part of this year, till there is clarity on the long term strategy of the US Fed.