Home Investing 75 bps Fed rate hike likely amid a “world of paradox”

75 bps Fed rate hike likely amid a “world of paradox”


In a historic move, the market anticipates that the Federal Funds Rate, the key policy tool of the Federal Reserve will breach the neutral rate of interest with the conclusion of the Fed’s 2-day FOMC meeting later today.

In one of the most eventful years in recent monetary history, the US Fed has already raised rates by 150 basis points (bps) through 2022 and has charted a path for approximately another 200 bps during the remainder of the year.

With Y-o-Y retail inflation surging to a four-decade high of 9.1%, the Fed is widely expected to raise the benchmark overnight interest rate by 75 bps, raising the policy corridor to a target range of 2.25% to 2.50%.

A three-quarters point hike would mark one of the fastest moves in Fed history, from the zero-bound to the neutral rate.

Undoubtedly, we are living in turbulent times. It was barely four months ago, that Fed rates – the central tool of global economic policy were at rock bottom levels. The Fed was still purchasing vast volumes of bonds each month to inject life into the economy amid the covid slowdown.

The neutral rate is that level of interest rate where the economy is neither stimulated nor contracted.  According to Reuters, this is commonly believed to be around 2.4%. It is important to remember that the neutral rate is a bit of a mystery wrapped in guesswork. One can not precisely state where the interest rate inflection point lies that could balance the economy perfectly between expansion to contraction. This is a theoretical rate which can not be observed directly and is estimated using data from previous years.

Surprise, Surprise, it’s 1%?

In its previous meeting, the Federal Reserve surprised markets to the upside by raising rates by 75 bps, the highest increase since 1994.

Given galloping inflation, some market participants expect that the FOMC could continue to accelerate rate hikes, while the monetary policy rhetoric could turn even more hawkish.

As reported in the CME FedWatch Tool, there is a sizable 23.7% likelihood of a 1% hike, which has not been seen since Paul Volcker was Fed Chairman in the 1980s. The latest data also shows that there is a 76.3% probability of a 75 bps increase to the 225 – 250bps range.

Naveen Kulkarni, Chief Investment Officer, Axis Securities, stated that at this stage, markets have largely priced in a 75 bps hike and that an upside surprise may affect the markets negatively, and be seen as “extremely hawkish.”

Runaway Inflation

High consumer inflation in the United States has been at least a decade in the making. Post the 2008 crisis, the Fed reduced rates to 0%, in a bid to stimulate growth. This implies that the price of money is virtually zero, a most unnatural state.

Money pays interest for a good reason. Well, for two reasons. Firstly, when you lend money, the lender is accepting a risk that the borrower may not repay the amount. The lender rightly expects to be compensated for this possibility.

Secondly, the lender is foregoing consumption today, in return for a higher level of consumption tomorrow. Higher is the operative term and implies that the lender should be compensated for the lost opportunity cost today.

However, contrary to this logic, the Federal Reserve, the most powerful economic body in the world, along with other developed country central banks decided to keep rates subdued, i.e., preserved an unnatural state in order to kick-start growth.

Once such unconventional measures have been adopted, the biggest challenge is perhaps to know when to reverse such a stance. Traditional economic theory tells us that interest rate cuts are short-run measures. Although economists can debate what constitutes the short-run, it is unlikely to have been as long as the Fed kept rates subdued.

Coupled with QE, unhealthy levels of low-cost debt built-up in the system, and their primary impact was to inflate asset prices and distort investment rather than drive real growth.

Beginning in late 2016, when the Federal Reserve tried to correct the interest rate path in the economy, monetary authorities were forced to abandon policy normalization towards the end of 2018. The upper limit of the target range remained flat at 2.50% through half of 2019, before the Fed began a gradual descent in 25 bps decrements.

However, come early 2020, fueled by the covid panic, interest rates plunged from 1.75% in February back to the zero-bound, where they had been for nearly a decade before the attempted normalization.

It is important to note that the Federal Reserve found itself in a precarious position at just 2.50%, with debt-fueled household budgets and mounting interest payments, leading to the economy being extremely sensitive to the mildest increases.

With the onset of Covid, monetary and fiscal intentions fused to an unprecedented degree, with the widespread roll-out of targeted fiscal policies, UBI-style programs and payroll protections.

Combined with supply chain disruptions, first due to country-wide lockdowns and other public health measures, and followed by the invasion of Ukraine by Russia, inflation soared and is yet to show any meaningful signs of easing.

In fact, inflation has only accelerated while the Federal Reserve has been attempting to at least reach the neutral rate as a first milestone.

The challenge for the Fed today is that much of the cost-of-living pressures are driven by supply-side forces. Interest rate hikes are largely demand management tools, and in many ways, the current inflationary scenario may be beyond the toolkit of central banks.

The war in Europe, gas prices in the eurozone, broken and inefficient logistics, Black Sea disruptions, extraordinary delays from China due to the zero-covid policy, and a shortage of microchips are some of the key factors dragging down global supply chains.

In fact, Stiglitz and Baker argue that “by making investment more expensive, they (the Fed) may even impede an effective response to supply-side problems,” which may exacerbate supply-side conditions.

Reflecting on the complexity of the situation, Noah Smith, previously an assistant professor of finance at Stony Brook University, and a popular Bloomberg columnist, infamously tweeted way back in 2017, “Conclusion: NO ONE KNOWS HOW INFLATION WORKS. Macroeconomists need to go back to the drawing board on inflation. Square one.”

The data paradox and recessionary fears

The challenge for the FOMC committee is to avoid a repeat of the 2018 reversal and to avert a possible recession.

The data that the Fed is relying on is both dovish (encouraging growth stimulus) and hawkish (encouraging inflation management), further complicating the situation.

Signals that the economy is robust or overheating:

CPI has surged to a four-decade high and has disregarded expectations of a peak, thus far.The Producer Price Index (PPI) is widely considered to be a leading indicator of the PPI and recorded a rise of 11.3% on annual basis for the month of June.US Consumer Spending was the strongest among 14 countries, according to McKinsey’s Consumer Pulse Survey published in July 2022.The labour market has remained tight, with the unemployment rate being sub-4% month after monthIn its most recent report this week, the American Petroleum Institute (API) reported a drawdown of over 4 million barrels, nearly four times the projected volumes, adding to bullish sentiments.The ongoing Ukraine-Russia war could drive higher inflation, particularly energy and food goods, pinching the average household.

Signals that the economy is cooling or heading into a recession:

US Consumer confidence declined for a third straight month, as per Conference Board Consumer Confidence Index to 95.7 from 98.4 in June 2022.The sister Expectations Index fell from 65.8 in the last study to 65.3, suggesting negative sentiments on short-term income creation, business opportunities and labour market conditions.The International Monetary Fund in its latest estimates cut global growth forecasts to 3.2% and 2.9% in 2022 and 2023, a decline of 0.4% and 0.7% since April, respectivelyJobless claims were reported to increase to an 8-month high of 251,000, suggesting that the inflation curve may indeed be flattening.Equities have performed very poorly in the high-interest rate environment, with the S&P 500 having declined 17.7% year-to-date, at the time of writing.Walmart, the largest retailer in the US and a bellwether stock is often seen as a gauge of consumer sentiment. The company’s latest release forecasted that adjusted profits per share could fall by 13% this year, indicating that consumer appetite may be waning. It is important to note that this would be fueled at least in part by rising prices.Although commodity prices remain historically elevated, they have eased post the Ukraine-Russia war as global growth projections have been revised downwards, and supply chains have improved in certain regions. For instance, copper prices have eased by 23.9% in the past 3 months.Mortgage demand fell 6% last week as reported by the Mortgage Bankers Association, registering the lowest level since 2000.With the US yield curve inverting, the markets are preferring to purchase long-term debt rather than near-term debt, signaling a deterioration in near-term expectations. This is often a precursor to a recession.

Fed decision and rate path

The Fed is likely to raise rates by another 75 bps today. Luke Tilley, chief economist at Wilmington Trust, stated that as long as inflation shows “no sign of abating, you are going to have a united front.” However, if inflation does peak, this may lead to diverging opinions between FOMC members.

As the cost of living eases or recessionary conditions worsen, the FOMC members will have to determine the best way forward between keeping rates high to manage supply-side heavy inflation but risk a recession and a downturn in job growth.

However, markets are not convinced that the Fed can continue to tighten as intended. Financial cracks are already beginning to emerge, such as the bear market in US stocks, deep trade imbalances and poor consumer sentiment.  

Given the data, policymakers could get pulled in both directions. Greg Daco, the chief economist at EY-Parthenon, noted that the U.S. is in “a world of paradox.”

In this regard, tomorrow’s release of US GDP would be a crucial indicator to follow, having seen a contraction in Q1.

If inflation were to peak in the near term, or the yield curve remains inverted, the Fed will likely be forced to cut rates quickly. Given that debt is much higher than in 2018 due to the pandemic era stimulus, and inflation is at record highs, the decision to substantially unwind policy normalization may prove much more challenging for committee members to embark upon.

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