Fed’s Biggest Rate Hike In 22 Years: What To Expect

The Fed will deliver the largest US rate hike in decades this week, as Jerome Powell joins the 50bps club.

The situation was urgent. Note the past tense. The war in Ukraine will likely keep food prices elevated around the globe, China’s anachronistic COVID containment strategy means supply chain disruptions will linger and shelter inflation has yet to crescendo in America, so price tailwinds will persist. But it’s at least possible that core inflation peaked in the US during Q1 (figure on the left, below).

That’s not to suggest tighter policy is no longer warranted. It’s just to say that the Fed is so far behind the curve that rate hikes might properly be viewed as an effort to accelerate a process that’s already unfolding, as opposed to a preemptive strike against a burgeoning threat.

Of course, the whole idea was to stay (deliberately) behind the curve and avoid preemptive action. That was implicit (and, in some ways, explicit) in the idea of “flexible average inflation targeting.” The Fed was concerned that, over time, consistent undershoots (versus their 2% target) would compel consumers to adopt a deflationary mindset. Now, the Committee has the opposite problem — they need to hike rapidly in order to ensure expectations don’t become unanchored in the other direction.

In any case, it’s conceivable that the balance of 2022 will be defined by a gradual cooling in core gauges against ongoing overshoots on headline inflation. Obviously, there’s still scope for core to overshoot too, but both March CPI and PCE suggested it may have reached a plateau. The question is whether it’s a permanently high plateau, or a dizzying summit from which we can safely descend.

The “safely” bit is key. Q1 data on employment costs will embolden the Fed. Compensation rose at the fastest pace on record during the first quarter, and the Committee watches that series closely. But adjusted for inflation, wages and salaries for private industry workers fell rapidly. Small wonder real income expectations are deeply depressed and perceptions of buying conditions are the worst in decades. Toss in plunging small business optimism and you’re left to ponder the prospect of aggressive Fed tightening into a downturn. As Warren Buffett put it over the weekend during Berkshire’s first in-person gathering since the pandemic, inflation “swindles almost everybody.” People who’ve just been “swindled” aren’t generally keen on repeating the experience.

Q1’s negative GDP print put the world’s largest economy on the brink of a technical recession, and although some were eager to write that off to the drag from trade and inventories, personal consumption missed too. The market and the Fed itself expect at least 150bps of additional rate hikes on top of the 75bps from March and May (figure below).

Some analysts have suggested that isn’t feasible considering it’ll be set against the tightening impulse from balance sheet runoff. Others say the Fed may deliver far more than 225bps this year.

“Policy actions at the May meeting appear set,” Goldman said. “We expect that the FOMC will raise the target rate by 50bps and announce that it will start reducing the balance sheet in June through passive runoff with an intention of scaling up to the peak runoff caps within three months,” the bank added.

Beyond those announcements, Goldman expects “minimal changes” to the statement “and lower-than-normal risk of either a hawkish or dovish surprise.” The figure (below) shows Goldman’s projection for the balance sheet.

Powell’s press conference is always the wild card. If there’s a “surprise” it’ll be because he gets it “right” or “wrong” in response to questions about, for example, the prospects for 75bps increments, something the market was forced to price as a tail risk following Jim Bullard’s trial balloon last month. Powell will also be queried about the timing of any active MBS selling.

“We think it is unlikely that the pace of tightening will accelerate [to 75bps], but not implausible under certain circumstances — for example, if inflation accelerates or long-term inflation expectations meaningfully increase,” Goldman went on to say, in the same Fed preview, before offering some additional color on the MBS question as follows:

We have always assumed that the FOMC will strongly consider selling MBS after the balance sheet reaches its equilibrium size sometime in early- to mid-2025 and the goal shifts to tilting the composition toward Treasurys, but the March minutes allowed for the possibility of selling before then. Our best guess is that the FOMC will not sell at an earlier horizon, mostly because FOMC participants have a strong preference for using the policy rate as the primary tool for adjusting monetary policy. We also think the FOMC is unlikely to sell because of discomfort with the slow pace of MBS runoff since mortgage rates have already risen surprisingly sharply, the share of MBS in the Fed’s portfolio will rise only modestly in the coming years and the principle of not holding MBS in the longer run feels somewhat dated now that asset purchase programs are a standard tool and are likely to include MBS in the future.

Ultimately, it seems unlikely that Powell will endeavor to push the issue on 75bps hikes or active MBS selling. The market is already pricing the tail risk of super-sized hike increments, and as Goldman suggested, active selling (versus passive runoff) isn’t any semblance of imminent, so unless Powell wants to deliberately shake up a market that’s already stirred (there’s a martini joke there), he’ll likely stick as close to the statement script as possible.

“We expect Powell to bring home the message that the Committee is ready to front-load interest rate hikes as it seeks to get monetary policy to a more neutral stance before the end of the year,” TD’s Oscar Munoz, Priya Misra and Gennadiy Goldberg wrote.

Like Goldman, TD doesn’t expect active selling during the balance sheet “normalization” process (the scare quotes are there to draw attention to the fact that the balance sheet will never return to pre-GFC levels). “QT will continue until the earlier of two scenarios: 1) the banking system sees signs of reserve scarcity or 2) Fed begins to cut rates,” TD went on to say, suggesting that if the Fed can engineer a soft landing, QT will likely continue until late 2024, “at which point some signs of reserve scarcity may emerge.” Remember: Thanks to the SRF, a rerun of September 2019’s funding market squeeze isn’t likely.

The May meeting comes at a delicate juncture for markets. Both stocks and bonds are struggling. The S&P is coming off its worst month since the onset of the pandemic. April was the worst month for the Nasdaq since 2008. And as of late last week, bonds were on track for the worst stretch in modern history (figure below).

Mortgage rates, meanwhile, are up more than two full percentage points since the start of 2022. Toss in a stronger dollar and the situation is fairly onerous.

The Fed is likely pleased with some, or even most, of that. After all, higher stocks and low long-end yields are conducive to easy financial conditions, and the whole point is to tighten things up in a bid to arrest inflation.

But it’s a delicate balancing act. Powell will downplay equities. Stocks, he’ll suggest, are a secondary concern, relevant only to the extent an extremely disorderly selloff might result in too much tightening over a very compressed a timeframe.

As for the economy, he’ll insist it’s strong enough to handle rate hikes. Which will be true. Right up until it isn’t.