Here’s what happened last night at the Fed meeting and press conference?

On the basis that it wanted to move quickly and not wait another 6 weeks, the U.S. Federal Reserve (Fed) front end loaded its tightening by increasing the federal funds rate (FFR) by 75 basis points (0.75%) last night.

The FFR now stands at 1.5% to 1.75%.

Guidance is that the next meeting in July could see another 50 to 75 basis points, with an overall plan of getting the FFR (the Feds primary tightening tool) to around 3.5% by the end of the year, and 4% by next year. 🥱

The Fed feels that kind of quantum and pace should allow it to get inflation back down to 2%, and anchored there.

Also, the central bank says it will only declare victory once in receipt of compelling evidence that inflation has abated. That will mean a few to several months of a new normal.

With the caveat that the Fed’s expectations rarely come to pass, here’s the June projection for the federal rates trajectory that was put up on the screen before the press conference last night.

June economic projections Dot Plot, extracted from Federal Reserve Press Conference on 15 June 2022.

So what?

Markets were expecting 75 to 100 basis point rise as evidenced by 2 year and 10 year bond yields before the announcement.

After the announcement, both markets took comfort that the hike was not a full 100 basis points (i.e., 1%) given the 40 year high inflation print.

Fed Chair Powell pretty much confirmed 50 basis points for the next one in July, as opposed to last night’s 75, and was quick to say that 75 basis points is not the new normal.

Also, as per the dot plot, the Fed sees peak rates in 2023 slightly above 4%, but spent almost no time on that. Rather, Powell’s key message was that he is expecting the FFR to be at 3% to 3.5% by the end of the year.

But what was most telling was the Fed’s (current) expected long term neutral rate of 2.5%.

Frankly, 2.5% is neither high, nor scary. This and 75 instead of 100, plus his other comment about the Fed not trying to induce a recession (however self-serving that comment was) probably caused the relief rally.

We know this because once Powell had finished his press conference, the 2 year and 10 year treasury yields were respectively 3.231% (down 21 basis points) and 3.3950% (down 21 basis points). Plus, the growthy end of the risk curve perked up and even some of the more promising altcoins were up between 20% and 60%.

In other words, the rate hikes and forward neutral rate were more than fully priced in already and the neutrality of 2.5% was lower than expected. No cause for tantrum. But is a celebration premature?

Now what (according to Powell)?

For all of its hawkishness, the Fed is still predicting dirt cheap (albeit not free) money, with a 2.5% neutral rate target. Hence, one of the reasons for the relief rally last night and today.

The Fed says it will be flexible and sensitive to incoming inflation and jobs data, and will be very careful in declaring victory on inflation, saying that it will wait for compelling evidence that inflation is coming down and that it can remain anchored at 2% while the labour market remains strong.

Powell’s making no secret that he’s playing a game of chicken with overtightening into commodity price strength and lower household spending and that he will continue until he whips inflation back to 2% or less.

And the market’s reaction so far seems to suggest that it is up for it. But we will see how long that view lasts.

In the meantime, the Fed says that while it is not seeing a broad economic slowdown it is closely watching consumer spending. But the Fed is often wrong and waits too long to pull on its levers.

And what if the Fed has it all wrong?

All the Fed can do is manage aggregate demand through interest rate movements, and effect liquidity by increasing or decreasing its balance sheet. It also sprinkles forward guidance on top of both of those levers and that fairy dust is it’s strongest tool.

Recent guidance has been relatively consistent - 2% inflation sustainably is the holy grail.

Then, higher rates lead to lower demand, lower spending, lower employment, lower corporate earnings. If supply chains were not broken and if there were no sanctions on Russian commodities, no food shortage and no tariffs on China - no problem! But there are.

Then, a smaller balance sheet means lower liquidity, less collateral available, less lending and borrowing, lower corporate earnings, decreases in the value of the world’s’ equity, bond and real estate collateral base, and then finally, liquidation if it’s taken too far.

Paired together, rapid and big interest rate hikes plus less liquidity in the banking system plus supply chains in disrepair (noting as we have before that the Fed cannot effect the supply side) is a recipe for a hard landing.

Based on the price action last night and today, there is no way the market has this potentiality factored in and for this not to effect markets going forward would mean that all the planets would have to line up for Powell and Lagarde. That probability is not high without some capitulation.

And if the Bank of Japan is unable to maintain its 25 basis point yield curve control on the 10 year, it will break that peg, rates will rise and that will put upwards pressure on bond yields in the US and Europe. 😲

This is also not factored into risk markets.

And therefore the unanswered question that remains is this - do we get to a Fed tightening point of a shade over 4% sometime next year and a smaller balance sheet and a chuffed Fed that can declare victory over inflation before something breaks (soft landing), or don’t we (hard landing)?

Risk markets are rolling the dice on the above and celebrating potentially prematurely. Markets have not factored in the difference between the aggregate demand lever (in the Fed’s wheelhouse) and the supply pump (in Putin’s wheelhouse) and it’s obvious in the price action.

Unless fiscal and geo-political policies change to rectify supply chains, then either (a) the Fed and ECB continue to play whack-a-mole with a feather and tip the world towards a hard landing recession, or (b) central banks capitulate and pause on their plans after a few more rate rises.

Mike

The Fed says it’s not trying to induce a recession, but words are just words

Here’s what happened last night at the Fed meeting and press conference?

So what?

Now what (according to Powell)?

And what if the Fed has it all wrong?