Monetary Policy & Inflation | US
Summary
- The Fed will be on autopilot at Wednesday’s FOMC meeting. It will hike interest rates by 50bp and start quantitative tightening.
- The Summary of Economic Projections is likely to show somewhat higher inflation and a higher interest rate trajectory. It should put the end-2022 federal funds rate around 3.25%, validating current market expectations.
Market Implications
- The current market pricing of rates would…
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Summary
- The Fed will be on autopilot at Wednesday’s FOMC meeting. It will hike interest rates by 50bp and start quantitative tightening.
- The Summary of Economic Projections is likely to show somewhat higher inflation and a higher interest rate trajectory. It should put the end-2022 federal funds rate around 3.25%, validating current market expectations.
Market Implications
- The current market pricing of rates would not be enough to cool the US economy.
- I therefore see scope for yield curve steepening.
- We are bearish equities given the balance of risks for the Fed.
Fed on Autopilot for Next Two Meetings
The Federal Open Market Committee (FOMC) will decide interest rates on Wednesday of this week. Inflation in the US is now at a 40-year high, with the latest data on Friday surprising to the upside at 8.6%. This eye-watering figure dashes hopes of a peak and pressures the Fed to curb price rises with more aggressive interest rate hikes.
Yet despite soaring inflation, the FOMC will be on autopilot at this meeting and the next in July. It will stick to its current plan to hike the federal funds rate (FFR) by 50bp at each meeting. This is because changing plans now would be an acknowledgement that it is too far behind the curve – that inflation is out of control. Also, there is probably no consensus among the FOMC for changing course.
Meanwhile, quantitative tightening will start this month. Under this, the Fed will reduce the size of its balance sheet by not reinvesting when bonds mature – a contractionary monetary policy that aims to decrease liquidity in the economy. It will set reinvestment caps at $30bn and $17.5bn for Treasuries and MBS.
Projections for Future Interest Rates
Released as an addendum to the minutes of the FOMC meeting, the Summary of Economic Projections (SEP) will set out participants’ projections for future interest rates. I expect the FOMC to validate current market expectations for 2022.
Those expectations rose after Friday’s higher than expected Consumer Price Index figures revealed inflation was at 8.6%. The market is now pricing in a 50bp hike at the September meeting, and it expects the end-2022 interest rate to be 3.25%.
Why Is the Fed Following the Market?
First, the Fed’s models of inflation have lost their predictive power. Its inflation expectations are stable, but inflation is soaring! In this context, market pricing is the main benchmark left to what is basically a rudderless Fed.
Second, showing less tightening than the market when inflation is soaring would further undermine the Fed’s credibility.
Third, the current market pricing of the interest rate trajectory is similar to what the Fed set out in its March SEP: a terminal FFR of 2.8%.
What About 2023 and 2024?
I expect the SEP to project interest rates for 2023-24 at levels similar to the end-2022 figure. Essentially, at this meeting, the Fed is bringing the peak interest rate forward in time, but not raising it much.
Predicting Inflation
In the SEP, the Fed will also forecast core personal consumption expenditures (PCE) inflation for the end of 2022. I expect it to raise the figure by 25bp from currently 4.1% to reflect recent price developments. Meanwhile, the figure for the end of 2023 could remain near 2.6%. More of an increase would further compromise the Fed’s credibility.
Market Consequences
The market is currently pricing interest rates at 3.25% by the end of 2022. And it thinks rates will peak around 3.3%. I think the Fed will follow this. However, I also think this is nowhere near enough to cool the US economy. Therefore, based on my expectations of the FOMC meeting validating market pricing, I see scope for yield curve steepening.
Longer run, we think markets could be wrong and the Fed goes further, raising rates to 5.25% or even 8%. This implies more downside to risk markets like equities, and we remain underweight given weaker growth prospects.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)