As widely expected, on its yesterday’s monetary policy meeting, Fed decided to increase its reference rates by 25bps to 0.25% -0.50% range and it expects to continue hiking in each of the following meetings this year. In this brief article, we present yesterday’s decision, drivers, and what to expect further.
After slashing rates to zero exactly two years ago, Fed now decided it is time to start increasing them again and hiked rates by 25bps. In the statement, it is said that ongoing increases in the target range will be appropriate which took some of the investors with a bit of surprise. This means that Fed will most likely increase its rates on each of the remaining 6 meetings this year which will take the fed funds target range to between 1.75% and 2.0%. That was confirmed on the dot plot with one official projecting rates to increase above 3.0% already by the end of 2022. Median projections of the Fed Committee show that in 2023 we could see ‘only’ hikes at every other meeting and that would leave us at 2.75% to 3.0% at the end of 2023 which should be the peak of rates in this cycle according to the latest projections. On QT, Fed stated that “the Committee expects to begin reducing its holdings of Treasury securities and agency debt and mortgage-backed securities at a coming meeting”. Talking about new economic projections, it could be seen that the neutral rate was lowered by 10bps compared to December’s projections, to 2.4% meaning that rates should peak some 50bps above the newly projected neutral rate. As expected, inflation projections were lifted, and Fed now expects PCE inflation to average 4.3% in 2022 (compared to 2.6% in December’s forecast) and to decrease to 2.7% and 2.3% in 2023 and 2024, respectively. On the other hand, GDP projection for 2022 was lowered significantly compared to December to 2.8% while unemployment is expected to stay at 3.5%, reflecting full employment.
In the opening statement, Mr Powell stated that the economy is very strong and that the labor market is extremely tight with 1.7 job vacancies for every unemployed person. Furthermore, Fed’s governor said that they still expect solid growth in the following years and that the labor market should remain strong despite higher interest rates. In the Q&A session, Mr Powell was asked several times whether rate hikes could be decelerated in case of slower growth (higher unemployment) driven by higher rates, supply chain challenges, and higher prices i.e., will Fed choose the stability of prices rather than the economy in case of stagflation. Mr Powell said that price stability is the basis for a strong economy and that you can not have full employment without stable prices. We read this as Mr Powell was not ready to choose between his mandates but rather to fight one battle at a time. For now, Fed sees 40-year high inflation as their main hurdle while the economy would be dealt with if needed. The most important thing, what the markets said on the first hike after three years? After the statement was released, the Treasury curve went North, with 2y jumping to almost 2.0% while 10y increased to 2.24%. However, after the Q&A session, longer parts of the curve were mostly unchanged while 2y yield was increased by 7bps (1.93%) and being only 25bps below 10-year yield, as market expects economic slowdown which would force Fed to pause its hikes, like the scenario seen in December 2018. Equity markets were mostly higher with Fed’s decision being behind us coupled with some positive news on the Russia-Ukraine conflict. Looking further, we expect rates volatility to subside a bit, as the market now calculated both hikes and QT while more positive news from Ukraine could have a two-fold impact. Namely, risk-on could weigh on safe heaven assets while the end of the conflict could also decrease expectations on energy inflation.
Chart. Fed dot plot