The Federal Reserve voted 10-1 to increase its target range for the effective federal funds rate by 75bps to 1.5-1.75%, while raising its median dot plot projection for 2022 by 150bps to 3.375% and 2023 by 100bps to 3.75%.
Esther George of the Kansas City Fed was the sole dissenter, favouring a 50bp hike in line with the Fed’s previous communications. In addition to the larger rate hike, the median 2022 dot plot suggests another 75bp hike in July, 50bps in September, and 25bps in November and December. Today’s decision comes on the back of a hot US inflation report for May, which showed inflation spike higher despite the consensus view that the peak came back in March. Together with signals that showed the pace of inflation increasing and becoming stickier, the rise in headline inflation prompted increased speculation on Monday that the Fed would abandon its previous signalling of back-to-back 50bp hikes in favour of a more aggressive move. Whether or not the Fed chose to prime markets by leaking information to the Wall Street Journal in violation of their media blackout or not is largely irrelevant at this point, because the market went all-in on the prospect of a larger rate hike. In standing by its original forward guidance, the Fed would have had to effectively loosen financial conditions if it chose to hike by 50bps at a time when inflation pressures were mounting. Thus, today’s decision to fall in line with market pricing wasn’t too surprising from the Fed. It does, however, come with the cost of eroding the credibility of the Fed’s inter-meeting forward guidance.
Given the 75bp hike and summary of economic projections were already priced in by money markets following Monday’s press reports, the broader reaction in financial markets was fairly sanguine: the dollar retraced some of its earlier losses while US treasuries mildly sold off as the risk of an underwhelming dot plot became priced out.
Summary of Economic Projections point to tighter financial conditions and a possible recession in 2024
An update on the Fed’s March projections was also released alongside today’s rate statement. Reading between the numbers, the Fed is now predicting a much narrower path for the monetary policy to navigate in order to tackle the inflation outlook without the US economy veering off track and falling into a recession. The upward revision of the Fed’s unemployment rate projections across the entirety of its medium-term forecast projection starkly reflected this. With the labour market tending to lag the rest of the business cycle, the largest revision was for 2024, which saw the forecasted unemployment rate bumped up by half a percentage point to 4.1%. According to the Sahm rule–a widely followed indicator that signals a recession when the 3-month moving average of unemployment rises by 0.5pp or more relative to its low over the last 12 months–the prospects of a “soft-ish” landing look increasingly dim.
Additionally, the range of central tendency for inflation in 2022, which shows where the FOMC consensus is situated, was halved from 0.6pp to 0.3pp. While the median PCE forecast was revised up substantially from 4.3% to 5.2%, the extreme narrowing of the range of forecasts is inconsistent with how uncertain predicting inflation has become in the current environment. The fact that the Fed had to deviate off course because of two inflation indicators, the University of Michigan inflation expectations index and May’s CPI report, highlights this inconsistency. Furthermore, the median inflation expectation for 2023 was downgraded by one tick to 2.6, while both the bottom and top ends of the range were raised from levels forecast back in March. While we acknowledge that substantially tighter-than-expected policy in 2022 could lead to lower inflation in 2023, the fact that the median zigged while the range zagged simply doesn’t pass the smell test.
Finally, on growth, the Fed is now indicating that a prolonged overshoot in inflation and tighter monetary conditions are set to weigh on economic activity. Across projections for the next three years, the Fed progressively downgraded its growth forecast, while the central tendency for 2023 dropped to as low as 1.3%.
This is in line with the idea that the Fed funds rate is set to peak next year, and with inflation pressure set to moderate, economic activity will soon become the priority for the Fed.
The inversion of US money market curves as early as Q4 2023 highlights just this as markets are now betting on looser monetary policy as the recession risks mount.
Downgraded growth projections highlight how narrow the Fed’s projected “soft landing” balancing act has become
Powell puts both 50 and 75 basis points on the table for July, but a slowdown in the hiking cycle is unlikely until the back-end of Q4
The emphasis for markets soon shifted to Chair Powell’s commentary in the press conference as markets gauged the Fed’s sensitivity to incoming inflation prints–given their forward guidance for the next meeting is no longer credible–and what the FOMC’s appetite is for aggressively taking rates higher above neutral than currently suggested by the dot plot. After pricing a slightly stronger dollar, higher Treasury yields, and lower equities in the immediate aftermath of the Fed’s policy statement and projections, the market reaction was quickly walked back throughout Chair Powell’s press conference as the Chair not only put the possibility of a 50bp hike back on the table but also relayed a calmer tone towards tackling inflation than suggested by the dot plot. Although many analysts will point to Powell’s comment that the next meeting “could be a decision of 50 and 75” as the reason for a renewed bid in risk assets, this merely summarised Powell’s much more conservative stance on the whole. When discussing the employment and growth projections, Chair Powell continued to believe that the Fed would be able to orchestrate a reasonably soft landing for the US economy, despite classical economic models pointing towards an incoming recession and markets pricing in a likely rate cut as early as Q4 2023.
Despite Powell’s comment that the Fed could revert back to less “unusual” hiking increments as early as July, the limited amount of data between now and the next meeting is unlikely to print favourably enough for the Fed to slow down its pace towards neutral rates.
This implies that front-end Treasury yields are likely to remain elevated heading into Q3, which should keep the dollar trading at elevated levels. Speculation over a slowing in the hiking pace is likely to be absent in the next two meetings given the resounding consensus about getting rates into restrictive territory. With the target range set to be 2.5-3% following a further 50bp hike at September’s meeting and inflation readings starting to slow, we will be monitoring pricing for the November and December meetings closely for the dollar’s near-term prospects. We will also continue to pay close attention to the impact wage growth and near-term economic activity data has on terminal rate pricing, given the influence it has had on the dollar’s medium-term trajectory. Signs that inflation pressures are beginning to moderate, medium-term inflation expectations remain anchored close to target, and a slowdown in growth conditions will likely be sufficient for the Fed to underdeliver on its dot plot by year-end with a potential pause in the hiking cycle occurring as early as December. This could mark an inflection point for the broad dollar should global recession fears abate.
Markets are becoming more emboldened with the idea of pricing in rate cuts as early as Q4 2023
Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analysis