This is moving fast now, but the Fed is still adding fuel to the fire.
By Wolf Richter for WOLF STREET.
The Fed struggled to restore its torn and mocked credibility as an anti-inflationary and today concluded the most hawkish Fed meeting in decades. After last week’s CPI report, which appeared to have ripped off all the doorknobs in the Fed’s Eccles building, everything was moved up a bunch: actual policy rates, projected policy rates through late 2022 and 2023, projected inflation rates, and projected Unemployment Rates . The only thing that was lowered was the economic growth projection.
The FOMC voted to raise all policy rates by 75 basis points, the most hawkish move since 1994, with just one dissenting vote (from Esther George, who wanted a 50 basis point hike):
- Federal funds rate target range of 1.50% – 1.75%.
- It pays banks interest on reserves of up to 1.65%.
- Interest on overnight repos up to 1.75%.
- Interest it pays on overnight reverse repos (RRPs) up to 1.55%.
- The primary lending rate that banks charge is 1.75%.
“Today’s 75 basis point rise is clearly unusually large and I don’t expect moves of this magnitude to be common,” Fed Chair Jerome Powell said in his statement at the news conference. But he said another 75 basis point hike could be on the table at the next meeting in July.
And the Fed will “look for compelling evidence” that inflation is moving lower before “declaring victory,” Powell said. This phrase “convincing evidence” has cropped up a lot among Fed governors lately. They look for more than a little squiggle in the line before retiring.
Expect much higher interest rates, much faster.
This is going fast now. Today’s “dot plot” in Economic Materials showed that all 18 FOMC members attending the meeting expected the Fed to raise its federal funds rate to at least 3% by the end of 2022, with 13 members expecting higher rates. The mean projection jumped to 3.4%.
The Fed would need to raise interest rates by another 1.75 percentage points to reach the median forecast of 3.4% by the end of this year.
The median projection for the policy rate at the end of 2023 rose to 3.8%. For 2024 it fell to 3.4%.
These key interest rates of 3-4% were unthinkable and impossibly high just a few months ago. It was something the Fed would never do and could never do, for whatever reason. Now they are on the table.
Quantitative tightening (QT) has begun.
QT started this month. The plan was drawn up in May. The Fed confirmed today that it is proceeding according to plan. During the introductory period from June through August, the Fed caps the amount of securities that can flow off the balance sheet to $47.5 billion per month ($30 billion in Treasuries, $17.5 billion in MBS ). Beginning in September, the caps will double to a total of $95 billion per month.
If not enough Treasury bills and bonds mature during the month to reach the cap, the Fed will make up the difference by maturing short-dated Treasury bills with no replacement. In other words, the cap is essentially a fixed amount that comes off the balance sheet.
The Fed will not sell securities directly at this point, but will instead let them mature without replacement. Most of the rebates for MBS come from the principal payments passed through, which are passed on to MBS holders when mortgages are paid off (when the home is sold or the mortgage is refinanced) or repaid through regular mortgage payments.
Still adding fuel to the fire.
With the Fed’s target range for the federal funds rate of 1.50% to 1.75%, the effective federal funds rate (EFFR) will be around 1.6% going forward.
But CPI inflation is now 8.6% and the ‘true’ EFFR is now negative 7%, which represents the amount the Fed has lagged inflation. Its slowness in responding to inflation is unprecedented in modern times:
Say goodbye to this “lack of work”.
Higher interest rates are expected to curb demand, which should take some fuel out of raging inflation. An increase in unemployment is expected as a result of the lower demand.
The Fed raised its forecasts for the unemployment rate, with the median forecast rising from 3.7% in late 2022 to 3.9% in late 2023 and 4.1% in late 2024.
This is the first time this cycle that the Fed is forecasting that unemployment will rise as a result of its crackdown on inflation. In the May meeting statement, the Fed still expected its magic to bring inflation down to its 2% target while the job market remained strong. That line went out the window in today’s statement.
And Powell acknowledged in the press conference that the Fed is unlikely to be able to bring inflation back to 2% without intentionally slowing the economy and raising unemployment.
Rising unemployment would obviously end the “labor shortage” and unravel some of the associated inflation and supply chain issues.
Expect higher inflation rates.
The Fed has been ridiculously behind in its forecasts for inflation rates over the past 15 months. But it lifted her, and today it pushed her further. Its median forecast for PCE inflation rose to 5.2% by the end of 2022. But it still hopes that PCE inflation will ease to 2.6% by the end of 2023 and 2.2% by the end of 2024.
But even that forecast could become invalid as “participants continue to view inflation risks as weighted up,” Powell said at the press conference.
Expect an economic slowdown: Avoiding a recession “will not be easy”.
The idea is to slow demand growth by some amount, just enough to bring down inflation but not enough to trigger a recession. But achieving that soft landing in the current conditions “isn’t getting any easier,” Powell said.
“What is becoming increasingly clear is that many factors that we do not control will play a very important role in deciding whether or not this is possible,” he said. “It will not be easy.”
“The events of the last few months have increased the difficulty” of getting that soft landing, he said. “There’s a much greater chance now that it depends on factors that we don’t control. Fluctuations and spikes in commodity prices could result in that option being taken out of our hands.”
In so doing, he implicitly acknowledged that the risk of a recession would be the price of bringing back this raging inflation.
Expect markets to figure out their own landing.
After previous sell-offs in the S&P 500 index of around 20%, the Fed began to include language in its announcements that suggested some kind of reversal. This was the Fed’s put. But that, too, went out the window. The S&P 500 Index is down 21% from its peak and the Nasdaq is down 31%, and none of that indicated the Fed is concerned.
On the other hand. The ongoing sell-off in the market and ongoing price declines in the housing market could be tough on the Fed, meaning the Fed may not need to raise interest rates in line with inflation or even above the inflation rate – above the red line on the EFFR-CPI chart – to keep inflation in check to throttle what would be a real carpet puller for the economy. Markets seem to have to figure out how to stand on their own amid rising interest rates and QT.
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