Fed: Aggressive increases this year that allows for more flexibility

Fed officials decided at this month’s meeting that they should increase interest rates in half a percentage point at their next two meetings and continue a series of aggressive moves that will provide flexibility to shift gears as needed. The May 4 FOMC meeting minutes highlighted the “strong commitment and determination” of all policymakers to achieve price stability, showing that officials paid attention to financial conditions as they prepared to raise rates further. If we look at the prominent details in the Fed minutes;

·        Most participants agreed that a 50 basis point increase in the target range would likely be appropriate in the next few meetings.

·        Fed officials noted that a restrictive policy stance may well be appropriate, depending on the improving economic outlook and risks to the outlook.

·        They said that demand for labor continues to exceed current supply.

·        Regarding the risks associated with the balance sheet reduction, several respondents noted the potential for unexpected effects on financial market conditions.

·        The minutes also showed that Fed personnel revised their inflation forecast upwards. They forecast the personal consumption expenditures price index to rise 4.3% in 2022 and slow to a 2.5% increase next year.

The minutes are probably at an important point in the sense that they provide more clarity on committee members’ sensitivity to the interest rate outlook. Market participants are questioning how much the Fed will need to raise interest rates. Although Powell has taken a more hawkish stance since the May 4 FOMC meeting – likely due to a surprisingly strong April core CPI reading – he ruled out the imminent possibility of a 75 basis point increase in his post-meeting comments. Some signs that core inflation is lower and the demand-supply balance in goods sectors is improving may be a factor as to why a 75bps increase was not considered at the May meeting.

Fed balance sheet development and federal funding rate midpoint comparison… Source: Federal Reserve, Bloomberg

In the weeks since the meeting, financial market volatility has soared as investors worried about recession risk, but investors digested the report’s less hawkish tone than feared. Possible references to a move to restrictive policy also suggest that authorities will not stop until inflation is on a convincing path back to its 2% targets. This appears to be a strategy that signals that policy will become more data-dependent after the Fed meetings in June and July. Bostic said on Monday that a pause in September “may make sense” if price pressures ease. Markets continued to show pricing of a 100 basis point rate hike in the next two meetings. Other than that, factors such as valuations or index sales will probably not be a factor considered by the Fed during the tightening of monetary policy and will ensure that the “Fed put” strategy does not come into play. What we call the “Fed put” is the market belief that the Fed will step in and implement policies to limit the stock market’s decline beyond a certain threshold.

At the meeting, officials also finalized plans to allow their $8.9 trillion balance sheet to start shrinking, putting additional upward pressure on borrowing costs. At the rate of shrinkage of the balance sheet, which will reach 95 billion dollars, there will be a balance sheet that will regress to pre-pandemic levels on the basis of the share of GDP in 3 years. Depending on the situation of the tightening, the Fed may accelerate the contraction with additional sales on the Treasury bonds or MBS side, considering the liquidity in the bond market. The current balance sheet tightening does not include direct sales from assets.

Comparison of PCE price indicators… Source: Bloomberg

There are signs of a broader-based acceleration of inflation in services categories, particularly rents and price hikes in the housing market, a sprawling inflation outlook focused on supply chain bottleneck risks from Russia’s war against Ukraine and quarantines in China. The Fed’s target for the personal consumption expenditures (PCE) price index, which is the preferred inflation indicator, is 2% per year. While this rate increased by 6.6% for the 12 months ending in March, the consumer price index (CPI) increased by 8.3% in April. The negative real income effect of high inflation on individuals also causes them to feel socially uncomfortable about the current administration and reduces Biden’s popularity. Therefore, it is normal that the economic administration in the US is not bothered by an aggressive Fed at the moment. Regarding the contraction of GDP in 1Q22; The Fed will see this as temporary and ignore it, along with the strong economic fundamentals argument. At this stage, the Fed wants to resolve the inflation that has been heated by the transition from demand for goods to demand for services, and therefore, it will want to prevent an inflation that may become demand-dominated with aggressive rate hikes.

While the Fed will reach neutral interest rates by the end of the year, it is possible that it will prefer a certain front-loaded fixed path in this timeline, so the markets will be ready for a few 50 bps rate hikes. After a few 50 bps increases, 25 bps intervals may be preferred again as neutral rates are approached. But the Fed’s choice to act quickly to reach neutral rates will require more than 50bps increases. The report is “hawkish” in its own right, but we were ready for these details after the FOMC because of the statements by Powell et al.

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