Fed Delivers Largest Rate Hike In Two Decades, Unveils QT

As expected, the Fed delivered the biggest rate hike in more than two decades on Wednesday.

The 50bps move was the second hike of 2022 and the largest since 2000.

Markets generally expect the Committee to deliver at least 150bps worth of additional tightening by year-end (figure below), with the majority coming over the next several meetings, consistent with officials’ express desire to front-load hikes in an effort to prevent inflation expectations from becoming unmoored.

“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices and broader price pressures,” the new statement reiterated. The Fed blamed “the invasion and related events” for “creating additional upward pressure on inflation” and cited COVID-related lockdowns in China as a factor that could “exacerbate supply chain disruptions.”

Jerome Powell will be at pains to explain why policymakers won’t be compelled to act even more aggressively going forward considering the US is experiencing what counts as runaway inflation for an advanced economy.

Officials uniformly support an “expedited” pace of tightening to bring rates rapidly up to neutral — and beyond, if necessary.

Complicating matters is the specter of an imminent slowdown. A negative read on Q1 GDP fanned recession fears, despite economists’ best efforts to explain it away by reference to the drag from net trade and inventories (figure below).

Data between the GDP release and today’s Fed decision was mixed. Personal spending held up in March, figures out late last week showed, but gauges of manufacturing and services sector activity disappointed this week, while Wednesday’s ADP report showed small businesses shed 120,000 jobs in April. Compensation and wage costs rose at the briskest pace on record in Q1, the latest ECI report indicated, even as inflation-adjusted pay fell sharply.

The new statement alluded to slower growth at the margins and the prospect of negative spillovers from the war, even as the Fed described household spending and business investment as “strong.”

In addition to the hike, the Fed formally unveiled plans to gradually reduce the size of a balance sheet that ballooned to $9 trillion in the two years following the onset of the pandemic. Runoff caps will be $30 billion and $17.5 billion for Treasurys and MBS initially, rising to $60 billion and $35 billion after three months. Consistent with the March meeting minutes, T-bills will fill any gaps in the event coupon maturities fall short of the monthly runoff caps for Treasurys.

Runoff will slow, then stop “when reserve balances are somewhat above the level [the Committee] judges to be consistent with ample reserves.” As we saw in September of 2019, judging that level is more art than science, but thanks to the standing repo facility, a repeat of that month’s funding squeeze isn’t likely. The Fed nodded to flexibility, noting that any of the QT parameters can be adjusted depending on the economic circumstances.

The decision was unanimous. In addition to new language on the risk posed by China’s lockdowns, and the slightly less upbeat assessment of the economy, the May statement contained one other notable tweak. The FOMC inserted a new sentence at the end of the second paragraph: “The Committee is highly attentive to inflation risks,” it said.