Fed is “of a mind” to Raise Rates

As was widely expected and signalled, in a unanimous decision, the Fed stayed pat on rates at their FOMC meeting yesterday. But all eyes were focused on the next meeting in March, at which point the Fed signalled it will raise rates “assuming that conditions are appropriate for doing so”, and end bond purchases. In terms of the ~USD9tn balance sheet, the message was that run-off will commence once the rate tightening cycle “has begun”; amended from once the rate hike cycle is “well underway”. 

There was no mention of magnitude or pace of balance sheet run-off, nor any clear guidance on whether the first hike will be a straightforward 25bps increase, or a 50bps hike (a suggestion that has been hitting newswires). This morning, futures markets are pricing in a larger than 25bps hike in March (at 30bps), and cumulative hikes totalling 127bps for 2022. 

On the Fed’s dual mandate, Chair Powell noted that the US is in a “historically tight labor market” and there is “quite a bit of room to move without hurting jobs”. In terms of inflation Powell admitted the price surge has been “larger and longer lasting than anticipated”. He said the US economy “no longer needs sustained high levels of monetary policy support”. We look to tomorrow’s PCE Core reading (the Fed’s favoured inflation measure) where the consensus is for a 0.5% increase in December, taking the full year to 4.8%.

In response to the hawkish rhetoric, equity markets went into risk-off mode: having rallied ahead of the meeting, the S&P Index closed marginally lower on the day, the yield curve flattened, and the VIX index spiked to highs last seen in February 2021. The Fed believes it has communicated well with markets, but the “Fed put” appears elusive of late, something that may panic stock markets ahead of the next meeting roughly seven weeks away. If recent history has shown us anything, a lot could happen in a few weeks, thus the Fed says it will remain dynamic.    

Inflation looks to be peaking, which would take pressure off the Fed to hike as aggressively as some market makers are suggesting; currently a pretty wide spread from 3-10 rate hikes this cycle. As the Covid pandemic appears to be shifting to endemic, and supply chain bottlenecks look to be easing globally we may see inflation moderate. However, amid the zero-Covid policy in China, supply chain issues may be exacerbated. Moreover, escalating tensions at the Russia-Ukraine border, two large commodity exporters, could put further pressure on already punchy commodity prices and keep inflation well above the Fed’s 2% target.  

Looking at recent key data prints such as US retail sales, Empire Manufacturing and Chicago Fed National Activity Index, all have released negative readings in December, with the former two readings well below market expectations. A US consumer recession could be brewing as high inflation erodes real earnings, which fell to –2.4%yoy last month, and pandemic stimulus payments dissipate. All this signals weaker growth; as we have said before, the Fed is walking a tightrope and there is risk of policy error. Nonetheless, if the Fed does raise interest rates it will then have room to manoeuvre when the next recession occurs. We believe high quality bonds tend to perform well under conditions where growth is decelerating, and this looks set to continue in the months ahead.

Fixed Income Team