In its much-anticipated June meeting, the Federal Reserve raised policy rates by 75 bps, which was above the stated 50 bps hike, to the range of 1.5% – 1.75%. The Federal Open Market Committee’s (FOMC) decision was driven by the surge in inflationary pressures to 8.6% in May 2022.
Stepping up its policy normalization efforts, this is the single largest rate hike by the Fed since 1994.
Chairman Powell had earlier indicated that the Fed would not seek to raise the rates by 75bps in a single meeting unless there was a substantial change in economic conditions.
Even though economic activity was firm in some respects, such as the addition of 390,000 jobs in the most recent payroll data, and the low unemployment rate, price pressures are recording fresh highs.
These are primarily due to pandemic-led supply concerns, elevated energy prices, and geopolitical disruptions from the Russia-Ukraine war.
Owing to high inflation, market analysts were uncertain whether the Fed would stick to its planned increase of 50 bps or take more aggressive steps.
Major financial players such as Goldman Sachs, Jefferies, GT, JP Morgan Chase, ING, and Barclays had revised their expectations upward to 75 bps.
The broader market also priced in a higher rate hike leading to a sharp sell-off across asset classes last week.
The S&P 500 was down over 20% YTD and bond yields rose to nearly 3.5%.
On the other hand, institutions such as Citigroup. and Bank of America Corp had expected the Fed to stay the stated course on policy normalization.
Other contributing factors may have been moderate gains in the Producer Price Index which is a leading indicator of the CPI, and the publication of the University of Michigan survey which showed that inflationary expectations were ‘de-anchoring’.
Source: BLS, FRED
Neil Dutta of Renaissance Macro Research, did not agree with the 75-bps rise, believing that “It suggests the Fed is losing confidence in its forecast…. it looks like they are panicking.”
However, since inflation expectations play a central role in the Fed’s model of inflation, Powell and the other FOMC members decided to forego a gradual process of rate hikes.
The only exception was Esther George of the Kansas Fed who advocated for a 50 bps hike.
The Federal Reserve also announced that it would continue winding down its balance sheet as stated earlier, with a target of letting $30 billion of treasuries mature each month and $17.5 billion in mortgage-backed securities. For its QT program, the Fed would be retiring maturing securities instead of re-investing these amounts.
In its much-awaited economic projections, which highlight the path forward for the Fed, the target rate for the end of 2023 was set at 3.8%.
GDP projections for 2023 have been revised downwards to 1.7%, but are expected to see an uptick to 1.9% in 2024.
Crucially, the Personal Consumption Expenditure index is a key gauge of inflation. This was projected to slow to 5.2% at the end of 2022, and to decline further to 2.6% towards the end of 2023.
Rate hikes would lead to a decline in demand, reducing consumption spending, which would in turn reduce price pressures, but also impact GDP growth figures.
The Fed expects that decisive action and aggressive rate hikes will guide the CPI to 2.2% levels by late 2024.
Greg McBride, Chief Financial Analyst at Bankrate believes that being well below the neutral rate (at which the economy is neither stimulated nor contracted by interest rates), the Fed is capable of raising rates by 75 bps. However, “that job is going to get tougher the more they push up rates, especially if inflation remains stubbornly high”.
Moreover, at higher levels, recessionary fears would also increase.
With the stagflationary effects of the Ukraine-Russia conflict showing no sign of easing, the Fed will likely to have to maintain a degree of flexibility depending on how conditions evolve.
Over the next two meetings, the market will be watching to see if the Fed deviates from its projections, or if interest rates move higher or lower.
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