Fed to keep focus on inflation

The Federal Reserve meets on July 27th this week and we expect a second consecutive 75bps hike, taking the Federal Funds rate to 2.50% on the upper bound. Markets are currently priced for slightly more than a 75bps hike with an outside chance that the Fed raises by 100bps as it continues to move aggressively against inflation. Over the rest of the year, markets are currently pricing in a peak in the Fed Funds rate of 3.4% to be hit at the end of 2022 before rate cuts start to come in and take policy rates lower over the course of 2023.

Perhaps more meaningful than the hike itself will be the tone of Fed chair Jerome Powell’s commentary after the decision. A ‘dovish hike’ where Chair Powell provides some accommodative language around the future direction of policy, indicating for instance that the Fed will ease off on hikes in the later months of the year, could give some relief to markets. Conversely, a hawkish Powell who shows no sign of flinching in the face of volatile financial markets and visible signs of weaker growth could wrench markets lower and potentially propel the dollar higher once again after some recent easing.

Growth in the US is evidently slowing. PMI numbers for the US fell into the contraction range in July for the first time since June 2020 when the economy was still in the midst of the Covid-19 pandemic. Housing market indicators are also weakening with existing home sales falling every month this year aside from January and sentiment among homebuilders falling precipitously. Faced with signs of a slowdown in the real economy the case is building for the Fed to temper their pace of policy normalization.

Inflation high, growth low and the Fed caught in the middle

Source: Bloomberg, Emirates NBD Research. Note: indexes rebased to Jan 2021 = 100.

the same time though, headline labour market numbers still appear strong—nonfarm payrolls have increased by 2.7m workers from the start of the year until the end of June while the unemployment rate remains low at 3.6%. Most importantly the inflation picture in the US is still resolutely bad with headline CPI increasing by 9.1% in June and the Fed’s preferred PCE deflator at 6.3% more than three times higher than the target level of 2%.

We expect the Fed is going to continue to fight against inflation to carve it out of its entrenched position as a drag on the US economy. Our baseline assumption is that the Fed follows this week’s meeting with a 50bps hike at the rest of the meetings this year, taking the Fed Funds rate to 4% by the end of 2022 with two more hikes pencilled in for 2023. Policy rates at 4.5% mid-way through 2023 are undoubtedly going to have a negative impact on investment, employment and growth over the next 18 months but that is precisely the objective of the Fed tightening policy. While they may be able to weaken the domestic drivers of inflation—demand for services, higher wages for example—the Fed has little control over the external factors causing high inflation in the form of oil prices or supply chain disruptions. An overly hawkish Fed now may help to bring inflation closer to target levels, even if the pain felt across the US, and indeed global economy, is acute.