Monex: Fed raises interest in line with expectations, but plenty more to come

March 17, 2022

The Federal Reserve raised rates on March 16th by 25bps, such that the target range now sits between 0.25% and 0.5%. While this was largely anticipated by most Fed watchers, especially after Chair Powell’s semi-annual testimony to the House and Senate in early March, the adjustment to the Fed’s Summary of Economic Projections (SEP) delivered the hawkish punch.

Since the December projections, conditions have undoubtedly become more inflationary: domestic inflation pressures broadened, headline and core CPI rose to multi-decade highs, the labour market continued to tighten in spite of Omicron, and the invasion of Ukraine resulted in a global supply shock. Most had expected FOMC members to revise up their respective dots for 2022 and 2023 accordingly, but most also expected the median projection to fall short of market pricing. Contrary to this belief, however, FOMC members gave their tacit support to the market’s pricing and signaled the likeliest course of monetary policy as things stand is that of seven successive 25bps rate hikes this year. Accounting for the adjustment in expectations this year, the median 2023 rate projection was lifted by 87.5bps—in line with the rate rise estimated in December’s projections but accounting for a higher base—while the FOMC officials now expect policy to stay on hold at 2.8% in 2024, up from 2.1% previously. Owing to the global stagflationary shock and the downgrade to their estimate of US growth, Fed members now expect rates to be lowered over the longer-term towards their estimated neutral rate of 2.4%, which has notably been revised down from the past estimate of 2.5%. This is likely a by-product of the front-loaded hiking cycle that is now expected. 

Analysing the rest of the SEP, the Federal Reserve substantially downgraded their real GDP forecasts with the median expectation for 2022 lowered to 2.8%. This new projection sits outside of the range of 3.2% to 4.6% laid out in the December projections, and is 1.2pp below last round’s median of 4.0%. Longer-term expectations were unchanged at the median, although the central tendency and range of projections marginally shifted. Meanwhile, the inflation profile was revised higher, with recent developments generating a more persistent impact on inflation than on growth. The median expectation for PCE was raised by 1.7pp to 4.3% for 2022, 0.4pp to 2.7% for 2023, and 0.2pp to 2.3% for 2024. It’s clear that geopolitical events and energy prices are a major driver of this new inflation projection given that the Fed now thinks headline PCE inflation will outpace core PCE, which was not the case in December.

This simultaneous downgrade of the growth outlook alongside a substantial upward shift to inflation expectations is consistent with a stagflationary negative supply shock. Stagflation is one of the most challenging economic environments for central banks to manage given that it puts the Fed’s two mandates of achieving maximum employment and price stability at odds. While Fed members hinted in pre-meeting commentary that the negative growth effects from the Ukraine-Russia conflict would play second fiddle to the fiery inflation backdrop, they left no questions about their resolve to subdue inflation with today’s aggressive dot plot expectations.

The dollar briefly went bid following the release of the March materials as FX markets re-aligned with Fed pricing in overnight interest rate swaps. However, the dollar’s bid wasn’t as seismic as many would have believed given the sizeable adjustment to the median dot in 2022. This is likely due to the expectation that Chair Powell will downplay the importance of the dot plot—a recurring feature of Powell’s recent press conferences—while also heavily outlining the risks to the Fed’s outlook, which will provide plenty of wiggle room for policy to deviate from current projections. 

 
The FOMC dot plot is sharply revised upwards for 2022 with the median expectation now sitting at 7 rate hikes this year 

 
Dollar unwinds its knee jerk rally as press conference progresses 

Despite his recent track record of downplaying the message delivered by the dot plot projection in press conferences, today Chair Powell broke form and reiterated the FOMC’s consensus that a succession of rate hikes is highly likely this year, with only the caveat that each meeting is “live” and that the Fed will be data dependent. Given the current inflationary backdrop, however, markets can be quite confident that rates in the US are set to rise sharply over the course of the next 18 months. This was reflected in the bear flattening of the US Treasury curve: two-year yields rose over 10bps, stopping short of the 2% mark, while the 10-year rose by less, reaching a peak of 2.24% before retracing. In OIS markets, participants continued to price in the probability of a 50bp rate hike in the coming two meetings from the Fed. The decision to hike by 25 or 50 basis points will largely be dependent on incoming labour market data and inflation expectations in our view. 

Even though Chair Powell didn’t explicitly sound dovish in today’s press conference, FX markets looked through the hawkish projections and began fading the previous dollar bid throughout the press conference. While there was no specific turning point within the Fed commentary, the stalling of the rally in 2-year yields at the 2% mark was notable and coincided with the leg lower in the broad dollar. 

 
Parameters for quantitative tightening almost completely hammered out; could come as early as next meeting

While the FOMC didn’t say much about its plan for quantitative tightening at the outset of today’s decision, Chair Powell revealed during the Q&A that the monetary policy committee made “excellent progress” on figuring out the details for the Fed’s upcoming balance sheet run-off over the last two days of deliberations. Powell said that the framework for run-off would look “familiar” to those who followed the Fed’s most recent balance sheet unwind, although quantitative tightening would happen faster and earlier in the cycle than last time. Since the details have nearly been finalized, Chair Powell suggested that QT could commence as early as next meeting, albeit with no guarantees. The meeting minutes, released on April 6th are expected to hold more information. 

The Fed’s previous framework followed a “cap-and-roll” approach, where the central bank set a fixed nominal cap for the value of assets it would allow to mature each month. It maintained this cap by re-investing any maturing treasuries or mortgage-backed securities that exceeded it, and conducting active sales to avoid a shortfall. Our estimates suggest that this cycle’s cap on maturing treasuries would likely start around $10bn per month and increase to about $70bn. This is roughly consistent with the degree of overall market liquidity drain and balance sheet shrinkage from the last cycle, which saw an initial cap of $6bn per month that peaked at $30bn. 

 
Based on the previous QT cycle and the increased level of liquidity, our estimates suggest the Fed’s nominal roll-off of US Treasuries could measure in the range of $10bn to $70bn per month