Fed goes big again

The Federal Reserve hiked the Fed Funds target rate to 2.5% at its FOMC meeting on July 27th, its second consecutive 75bps hike. Policy rates in the US are now as high as they reached during the Fed’s last hiking cycle from 2015-18 though this year the Fed has achieved that level in just five months. In its commentary in announcing the decision, the Fed noted that some “recent indicators of spending and production have softened,” an allusion to some of the weaker data that has shown up from the US economy lately such as PMI surveys falling below 50 or a downturn in the property market. Nevertheless, the Fed’s statement said it was “strongly committed to returning inflation” to target levels and that it was “highly attentive to inflation risks.” Unlike the last 75bps hike in June, this vote was unanimous among Fed policymakers.

In the press conference following the decision Fed chair Jerome Powell said that “another unusually large increase could be appropriate” when the Fed meets again in September but didn’t commit to a range for the hike like he did following the June FOMC. Powell also pushed back against assumptions that the US economy was in a recession, highlighting the still strong performance of the labour market.

Policy rates at 2.5% are now at the level that the Fed seems to believe is neutral and given the clear messaging that inflation is the main priority to address, we maintain our expectation that the Fed will continue to hike rates into a restrictive stance to carve inflation out from its entrenched position in the US economy. In his press conference after the announcement Chair Powell said the US economy needed a “period of growth below potential in order to create some slack” and that there will be “some softening in the labor market.”

By all accounts, and on aggregate at least, the labour market in the US remains in strong shape to withstand a tightening of policy. Nonfarm payrolls have been adding more than 360k jobs per month in Q2. There has been an uptick in initial jobless claims since the end of March but continuing claims have held relatively stable.

By contrast the inflation picture remains resolutely bad. Inflation in the US hit 9.1% year/year in June and is likely to remain high over the summer months, even if some components like fuel prices have started to move lower. The Fed has committed itself to seeing inflation move lower on a sustained basis before it considers halting the pace of policy normalization and we are hesitant that the next two inflation prints—July and August— will give the Fed much conviction that the inflation story has turned. Chair Powell alluded to the dot plot as the guidance for where the Fed would take policy rates until the end of the year but at 3.4% at the end of 2022, that would imply a considerable downswing in inflation in the final months of the year.

We expect that the Fed will follow up the July meeting with 50bps hikes at the September, November and December meeting, bringing the Fed Funds rate to 4% by the end of this year, considerably higher than market expectations of about 3.3%. For 2023, the Fed may shift to a slower pace of normalization if it feels hikes are still required to eliminate the threat inflation poses to the sustainability of the US economy.