Fed on course to go well past neutral rate

US FOMC hikes, as expected, by 75bps; Chair Powell does not rule out more outsized hikes, but we sense a desire to slow the rate cycle a tad.
Group Research, Taimur Baig28 Jul 2022
  • Key is the demand drivers of inflation—wage and jobs growth, business and consumer sentiment
  • Financial market considerations are secondary at this stage, in our view
  • If core prices ease and jobs reports become sedate, the Fed will hike by no more than 50bps in Septe
  • A winter of discontent, with elevated energy prices even as demand softens, could be on the cards
  • Peak inflation will be followed by peak rates; peak USD may be even later
Photo credit: Unsplash/Adobe Stock Photo

An expected hike, now what?

In a move that was well telegraphed weeks ago, at the conclusion of its July 26-27 meeting, the US Federal Reserve’s Open Market Committee raised the target range for the federal funds rate to 2¼-2½%. Additionally, the FOMC stayed the course with reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities.

In its statement, the FOMC pointed out that some indicators of spending and production have softened lately, although the labour market has remained strong. The FOMC remains uncomfortable with the prevailing inflation situation, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.

Data dependency is key going forward, with the expectation that the demand side, starting with housing, would begin to soften. Even if supply side factors keep energy prices elevated, the Fed would be encouraged by the efficacy of its policy channel, with large parts of the economy dependent on the cost of financing. Wage and jobs growth, along with business and consumer sentiment, would span the key indicators that the markets and the Fed would follow. Industrial production and energy demand would be important too. 

From a money supply perspective, the Fed’s actions could have far-reaching implications for assets, but its impact on inflation is unclear, given the peculiar nature of the prevailing cycle. Also, while broad money growth rate has been coming down, the fact remains that the Fed balance sheet remains extraordinarily large, with its adjustment so far being barely discernible from a long-term perspective. Clearly, the asset market rally that followed the Fed policy announcement does not seem to indicate any nervousness about ongoing quantitative tightening.

As for the next action of the Fed, Chair Powell did not rule out yet another outsized hike in the next meeting in September, but our view is that a 50bps hike is more likely, as we expect wage growth to soften and some of the sell-off in oil and food over the past couple of months to begin showing up in the consumer price index. This doesn’t mean the Fed is about to turn dovish. We still see the Fed hiking by at least another 100bps this year, taking the policy rate well past what is considered to be the neutral rate. The risk is that the Fed would hike by an additional 150bps (taking the Fed funds rate to 4%) if the labour market remains strong.

But there is always the risk at the other end of the spectrum, which is to cause an asset market crash and economic recession by relentless rate hikes. Given that a large part of the inflation outcome is related to the pandemic and the war in Ukraine, the Fed may well have to be ready to deal with inflation (from the supply side) that remains somewhat high even as it slows the economy down.

Inflation may have already peaked, but it could remain uncomfortably high for a while. A winter of discontent, with elevated energy prices even as demand softens, could well be on the cards. Peak inflation will be followed by peak rates; peak USD may be even later.

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Taimur Baig, Ph.D.

Chief Economist - Global

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