FOMC Preview: A Done Deal?

Summary

• Battling expectation-beating inflation, the Fed is likely to hike interest rates by 75bp at the FOMC meeting on Tuesday and Wednesday.
• The market expects interest rates to hit 3.5% by end-2022, then for the Fed to cut rates in 2023.
• Fed Chair Jerome Powell will probably rebuff market pricing. But strong hawkishness could further undermine the credibility of the Fed’s forward guidance.

Market Implications

• Markets have already priced in 75bp for this meeting.
• I do not think Powell can convince them the Fed will not cut rates in 2023.
• This implies limited impact from the meeting.

Fed to Hike 75bp

Inflation is bad, and central banks know it. The Bank of Canada dramatically hiked interest rates by 100bps this month to tame runaway price rises. And last week, the European Central Bank surprised markets with a 50bp hike of their benchmark rate.

But is another shock on the table for the Fed at this week’s FOMC meeting?

After all, inflation data recently came in hotter than expected at 9.1%. And the Fed hiked by a larger-than-expected 75bp in June, breaking the pre-meeting media blackout to announce the intention in a move that saw risk rally – then reverse suddenly.

This week, however, we expect another 75bp with few surprises, bringing the federal funds rate (FFR) to 2.5%.

The Fed likes to announce policy changes ahead of actual policy meetings. When market expectations are misaligned with Fed intentions, the latter tends to provide hints to a few trusted reporters. Since we have not heard from these reporters, we can safely assume the Fed will hike 75bp, as implied by the very public debate among FOMC members ahead of the pre-meeting blackout.

What About the Rest of 2022?

Based on FFR futures, the market expects the end-2022 FFR at 3.5%. That is, past July, the market sees only about 115bp in additional hikes. The Fed is probably happy with this. It is near the 3.4% forecast in the Fed’s June Summary of Economic Projections (SEP).

Market pricing is consistent with the Fed stressing it was frontloading hikes rather than raising the FFR trajectory. Also, after this week’s 75bp hike, the FFR will be near the level the Fed thinks is neutral (2.5%). These imply that from July onwards, hiking should slow, as priced by the market.

What About 2023?

The market sees the FFR peaking between the December 2022 and February 2023 meetings and is pricing nearly a full cut by the June 2023 meeting. By end-2023, the market sees the FFR back at 3%, contrasting the most recent SEP, which shows the FFR rising to 3.8%.

Powell will likely push back against market pricing for 2023 for three reasons. First, market pricing is inconsistent with the Fed narrative of soft landing as a base case. Second, Powell probably knows inflation may not slow as easily as the June SEP envisioned. Third, the Fed moves slowly and will likely require compelling evidence to lower its FFR trajectory

I do not expect Powell will be able to convince markets to remove the 2023 cuts. This would require more hawkishness on his part and (further) risk the credibility of the Fed’s forward guidance.

Updates on Quantitative Tightening

I expect Powell will hint at what comes next for quantitative tightening. Alongside hiking, reducing the balance sheet is intended to decrease liquidity in the economy, normalise interest rates, and help control inflation.

I expect the reinvestment caps for bonds to be increased to $90bn a month from December, compared with $60bn a month up to November. I also expect the Fed to proceed with outright sales of MBS in Q4, possibly starting with $35bn a month.

Market Consequences

I expect this meeting to have limited market impact since 75bp is already priced in, and Powell is unlikely to convince markets the Fed will hike further in 2023.