The Federal Reserve today voted unanimously to raise the target range for the effective federal funds rate by 50 basis points to 0.75-1% and outlined the first steps to its “phased-in” quantitative tightening programme.
The move in interest rates was largely signalled in the Fed’s inter-meeting communications and thus didn’t take markets by surprise, despite it being the largest increase in rates since May 2000. Instead, the market focus has been on the Fed’s choice of wording within the policy statement ahead of Chair Powell’s press conference, especially around the description of domestic activity and inflation conditions.
Apart from referencing the increased inflation and growth risks stemming from China’s zero-Covid policy and outlining the growth risks from the war in Ukraine with greater certainty, the Fed’s policy statement didn’t offer many adjustments.
Additionally, against some expectations that the Fed would change the wording around the future tightening path to “expeditiously” return rates to the neutral range, the rate statement maintained the wording from March that “ongoing increases in the target range will be appropriate”. This, along with the fact that no FOMC member dissented in favour of a larger 75bp move as hinted at recently by James Bullard, meant that the latest decision was deemed on the dovish side by markets. US Treasury yields dropped and the dollar exhibited mild downside against G10 currencies. The initial market reaction is reasonable given the lack of surprises in today’s decision as the Fed seeks to keep as much optionality in policy as possible. We expect to see more definitive forward guidance from Fed Chair Powell in the subsequent press conference.
With regards to its balance sheet, the Federal Reserve formalised how it will begin to reduce the value of its asset holdings. The implementation note on quantitative tightening suggested that the initial caps, which limit the value of the assets allowed to roll off the balance sheet, would begin on June 1 at $30B per month for Treasuries and $17.5B for agency mortgage-backed securities. The Fed would maintain those caps for three months, before doubling them to $60B/$35B for Tsys/MBS in September.
The lack of a gradual ramp-up period means the Fed’s actions in the bond market could have a more jarring impact, but given the relatively short amount of time before the Fed hits its maximum caps, the difference in effects between the two policies should be minimal.
Fed’s plan to phase in its maximum roll-off caps isn’t smooth, but it’s simple
Treasury yields plummet as Powell’s tone suggests a more conservative Fed reaction function will be enough to tame inflation
Despite starting the press conference by saying that inflation is “much too high” and the labour market is “extremely tight”, which initially helped boost Treasury yields and the dollar, the overall tone of the Fed’s latest press conference has been on the dovish side relative to broad market expectations. Fundamentally, Chair Powell scratched off the probability of a 75bp hike at incoming meetings by stating that this isn’t being “actively discussed” by the committee, while also stating that there are no signs of longer-term inflation expectations de-anchoring—a development that would warrant a much faster timeline for rates to enter restrictive territory. Another dovish sign was Powell’s increased conviction that growth conditions will hold up, saying there’s a “good chance to have a soft or soft-ish landing,” implying more aggressive policy actions at the cost of growth won’t be necessary to return inflation back to target over the medium-term.
Given that core inflation likely peaked in March, without a surprise turnaround in measures of underlying inflation, the Fed is likely to follow up with another 50bp hike on June 15. Powell said that 50bps would be deliberated at “a couple of meetings,” but the ultimate outcome will depend on how economic and financial conditions evolve compared to expectations.
In light of today’s meeting, our view that the Fed will conduct another 50bp hike in June before reverting back to hiking by 25bp increments at every remaining meeting this year to bring the target range to 2.25-2.5% remains, with risks tilted towards one further 50bp hike in July.
While the view that core inflation has topped out is in line with market expectations, the more conservative tone by Powell has seen markets start to price out the probability of two more back-to-back 50bp moves after June’s meeting, while two-year Treasury yields have moderated back closer to the mid-point of the Fed’s longer-term estimated neutral rate of 2.5%. The drop in US yields, spearheaded by front-end rates, highlights that markets are interpreting today’s Fed meeting as more conservative than previously expected. This is offering a welcome boost to US equity indices, while the dollar is broadly offered across the FX space; especially against low-yielding and higher beta currencies. We expect the softer dollar to persist through to the end of the week unless regional Fed presidents strike a materially more hawkish tone than Powell or US jobs data show a substantial increase in wage growth on Friday.
Front-end Treasury yields drop with the dollar as Powell sounds more dovish in the presser
Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analyst