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Fed hikes rates by 75 bps; reaches twin milestones ahead of GDP data

In line with market expectations, Chairman Powell and the members of the FOMC, raised the federal funds rate by 0.75%, for a second consecutive time.

In a unanimous vote, the policy corridor was raised to 2.25% – 2.50%, which is the fastest pace of tightening since 1981 in response to the surge in June retail inflation to 9.1%.

The Fed has re-iterated that in line with its June Summary of Economic Projections, the policy rate is expected to be raised to 3.25 – 3.5%, suggesting that the institution is looking to hike another 100 bps by year-end, although the pace is not yet clear.

Crucially, the Fed has reached two important milestones:

Bringing the federal funds rate in line with the neutral rate, a theoretical point where economists expect that the interest rates are not too low to stimulate or too high to constrain economic activity. This is often considered to be around 2.4% for the United States.
Reaching the peak of the previous hiking cycle, i.e., 2.5% in 2019, before entering into a policy reversal.

Other than increasing rates, the Fed will also continue with quantitative tightening to the tune of $47.5 billion a month, comprising both treasuries and mortgage-backed securities. This quantum is expected to be doubled in September.

The immediate effects

With higher rates, business and household debt become more expensive, particularly for variable rate loan holders.

As the Fed funds rate rises, debt becomes costlier across the board, and with the US being largely a debt-driven society, borrowing costs rise for personal and household consumption, as well as for company expenditures. With local banks carrying much of the burden in the US, community, regional and national banks will likely tighten lending practices, especially for small businesses.

With stricter bank measures not only in terms of interest rates but with the roll-out of tougher risk management measures and capital requirements, small businesses may find their access to finance drying up.

Households would face similar challenges with the cost of debt lifting sharply from 0% earlier this year, and pandemic assistance having been largely exhausted.

Inflation fears giving way to recession concerns?

The policy narrative has begun to shift, and markets are increasingly concerned about a recessionary future compared to an inflationary one.

For instance, a recent survey showed that 63% of respondents expected the Fed’s 2% policy to lead to a recession, whereas 22% did not believe so. In addition, 55% of surveyed financial market participants, including fund managers and financial analysts felt that the USA would be in a recession in the next 12 months.

One of the key elements contributing to a recessionary mood is the sustained drawback in commodity prices.

Source: MarketWatch

To curb inflation, which is still running hot in the United States, Powell stated, “We think it’s necessary to have growth slowdown…we need a period of growth below potential to create some slack so that the supply side can catch up.” As a result, he believes that another “unusually large” rate hike may be due in the September meeting to dampen consumer demand if “inflation continues to disappoint.”

However, he added that there is likely some “additional tightening in the pipeline” on account of the delayed economic reaction to monetary policy decisions. Simply put, monetary transmission is not an instantaneous process, and would require Fed monitoring to avert slipping into recession

Transmission is the mechanism by which changes in the Fed rate reverberate throughout the economy until they meet intended policy objectives regarding growth and inflation.

According to the San Francisco Fed, “…the major effects on output can take anywhere from three months to two years. And the effects on inflation tend to involve even longer lags, perhaps one to three years, or more.”

In the FOMC’s press release, the opening sentence states that “Recent indicators of spending and production have softened,” suggesting that Chairman Powell believes that the committee does need to actively monitor recession risks as well.

Greg McBride, Chief Financial Analyst at Bankrate, believes that this is too early for the Fed to dilute its rate hikes, since CPI is still at a four-decade high, and PPI, a leading indicator of the CPI has been recorded at 11.3% on an annual basis. However, he does expect that if inflation begins to moderate, the pace of rate hikes will slow.

Supporting the view that rate hikes must continue for the foreseeable future, Chris Hurn of Fountainhead, a small business lender, stated that “A few hundred basis points, people can withstand.”

Way forward and forward guidance

Interestingly, Jerome Powell has shifted his stance away from delivering careful and deliberate forward guidance, stating that the FOMC will not provide “clear guidance as we did on the way to neutral,” while continuing to tighten to moderate levels.

He reiterated during the Q&A session that policy decisions would be made on a “meeting to meeting” basis, and adjustments to the intended path will depend on incoming data.

This is partly because markets are significantly more uncertain given the global geopolitical tussles, the spread of covid and other potential supply shocks.

The next Fed meeting is scheduled to be after an 8-week gap in the month of September, prior to which the FOMC will benefit from a lot of fresh economic data including the GDP data for Q2, two CPI prints, two labour market updates and a longer time series of commodity prices.

Although a further hike is expected in September, given that pandemic-induced fiscal stimulus and quantum of debt, as well as retail inflation, is much higher than in 2018, it will be interesting to see if the Fed can hike rates as it principally plans to do, or if it will be forced into a reversal as in 2019 amid recessionary concerns.

Economists at Bank of America Securities have already revised their Fed rate expectations downward, and anticipate the Fed to reverse course in early 2023.

Upcoming Data

US GDP data is to be published tomorrow, and will provide crucial direction on the following hikes.

In Q1, US GDP was recorded at -1.6%. Market watchers will be curious to see if there is a contraction in the second quarter of the year as well.

Two consecutive quarters of contraction are often considered to mean the economy is in recession. Strictly speaking, this is not true. Recessions in the US are identified by the National Bureau of Economic Research (NBER).

The NBER states that “The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions.”

Thus, US defiitions of a recession are actually subject to judgment of the experts in charge of business cycle dating.

Earnings data to be released later this week will also provide an advance indicator of how consumer purchases are trending, and what scope there may be for corporate re-investments.

The post Fed hikes rates by 75 bps; reaches twin milestones ahead of GDP data appeared first on Invezz.

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