Fed Hikes Rates Most Since 1994 In Dramatic Mea Culpa

The Fed hiked rates by the most since 1994 on Wednesday, in a decision that might aptly be described as a historic mea culpa.

The 75bps move punctuated an awkward about-face by US policymakers who, after spending the better part of the pandemic recovery insisting elevated inflation would prove “transitory,” found themselves staring down a crisis in 2022, when the war in Ukraine drove up food and energy costs, insult to injury for consumers already struggling with sharply higher prices.

“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices and broader price pressures,” the Fed said Wednesday, hewing to familiar language in the new policy statement. “The Committee is highly attentive to inflation risks” and “strongly committed to returning inflation to its 2% objective,” officials added. Esther George dissented in favor of a 50bps move at Wednesday’s meeting.

Rates may rise to 3.4% by year’s end, implying an additional 175bps of tightening or more. Plainly, the Fed intends to take policy into restrictive territory this year and next. That goes without saying at this juncture. After that, assuming inflation moderates, rate cuts can presumably commence.

The economic projections showed officials are prepared to countenance a higher unemployment rate in order to help bring the labor market back into balance in pursuit of lower inflation. If past is precedent, the US would be unlikely to avoid a recession if the unemployment rate rises by half a percentage point on a sustained basis relative to recent lows.

Growth is seen moderating further compared to March’s projections, and inflation forecasts were “marked to market,” as it were. The figure (above) shows the evolution of the projections over the most recent three SEP meetings.

“Overall economic activity appears to have picked up after edging down in the first quarter,” the Fed said, of the growth outlook. “Job gains have been robust in recent months, and the unemployment rate has remained low.”

There was no change to the Committee’s plan for balance sheet runoff. Market participants are keen on any indication that the Fed is more inclined to resort to active sales of mortgage backed securities in an effort to put pressure on the housing market, where a relentless rise in property values is now feeding through to shelter inflation on a predictable lag (figure below).

Mortgage rates are up dramatically, and the most recent data uniformly suggests the market is already cooling rapidly. Homebuilder sentiment dropped to a two-year low in June, according to the latest read on NAHB’s gauge, released on Wednesday.

Market-based measures of inflation expectations have moderated alongside an acute tightening in financial conditions, but the outlook among consumers has deteriorated amid record-high gas prices and a double-digit annual increase in grocery bills.

The latest New York Fed poll showed year-ahead inflation expectations matched a record in May, while longer-term expectations in the University of Michigan’s closely-watched sentiment survey moved to the highest in a dozen years early this month (figure below).

Although it’s too late for the Fed to win the battle, the war isn’t yet lost. The path to victory goes through the expectations channel, which policymakers can still short circuit if they move aggressively to curb consumer psychology.

Although the idea of a 75bps hike increment was bandied about earlier this year, it remained an outlier view, to the extent it was taken seriously at all. But May’s CPI report, which showed inflation continued to broaden out last month, was a bridge too far.

On Monday afternoon, Nick Timiraos, the Wall Street Journal‘s Fed conduit, conveyed policymakers’ intention to consider a three-quarter point move, a prospect that would’ve seemed unthinkable just six months ago. US rates responded with a violent repricing. Most Wall Street banks subsequently adopted 75bps as their base case.

The question now is whether the Fed has the fortitude to follow through at a time when the economy is losing momentum and is all but guaranteed to decelerate further over the next several months. US stocks fell into a bear market this week and credit market “fear gauges” are flashing red.

Of course, it’s possible the Fed’s newfound zeal for the Paul Volcker medicine will actually calm markets by reassuring investors that the stewards of the global economy aren’t completely asleep at the wheel. Mohamed El-Erian on Wednesday correctly noted that “the Fed’s misplayed attempt at precision” is contributing to heightened volatility.

“Its signaling of two 50bps increases a few weeks ago first led markets to contemplate a September pause in the rate cycle [but] that thinking was then firmly displaced by speculation about an immediate 75bps increase on a journey to a terminal rate well above anything mentioned by the Fed,” El-Erian wrote, in what I must say was a good Op-Ed. “That caused yet more undue volatility in markets and with that comes greater distancing for the Fed from the ‘first best’ policy response and a deepening of a lose-lose policy dilemma that is largely of its own creation”

Bill Ackman, who criticized the Fed in somewhat caustic terms last month, called for more. “100bps tomorrow, in July and thereafter would be better,” he said, prior to Wednesday’s decision. “The sooner the Fed can get to a terminal fed funds rate and thereafter can begin to ease, the sooner the markets can recover.”

That’s a bit like suggesting policymakers should chase their own tails, but if acute uncertainty around the Fed’s commitment to bringing inflation under control is contributing to market angst (and it is), then any clarity about their conviction may be welcomed. The June statement said the Fed anticipates “ongoing” rate hikes.

Officials demonstrated no shortage of temerity when it came time to rescue the country (and the world, for that matter) from a deflationary spiral in March of 2020. Whether they’ll be equally intrepid in their efforts to avert ruinous inflation remains an open question. But Wednesday’s historic shot across the bow served notice: The fight is now well and truly joined.