Sticky inflation forces Fed towards more hawkishness

One thing that could have given the confidence to the Federal Open Markets Committee (FOMC) for this hawkish stance is the strong labour data as well as the robust GDP numbers in the third and fourth quarter. US GDP grew 3.2% in the third quarter and the advance estimates hint at 2.9% growth in the third quarter. The final data will be out on 23rd February.

If one looks at the dot plot chart pencilled by the FOMC members, there are 3 things that come out explicitly. Firstly, in last few weeks, there has been a shift towards more hawkish expectations. We will see that in greater detail when we review CME Fedwatch data. Secondly, Fed members believe that gradual rate hikes may not work as they get absorbed too easily. The answer lies in front-ending and higher terminal rates. Lastly, Fed members believe, growth triggers and labour data is strong enough to justify longer hawkishness.

What the CME Fedwatch data tells us

CME Fedwatch reflects implied probabilities of future rate hikes based on Fed futures pricing. It is market based pricing of hawkishness risk. The table below captures probabilities of different rate levels after the remaining 7 Fed meets in year 2023.

Data source: CME Fedwatch

Since November, Fed had turned less hawkish, but that appears to be changing in February. With the rate hikes slowing, it looks like it may take much longer than the end of 2023 to put the US economy on path to 2% inflation. Obviously, the FOMC members have turned distinctly hawkish in February. Here are some key takeaways from the CME Fedwatch data.

• There has been a clear rightward shift in the data. Now, markets are targeting Fed rates in the range of 5.50% to 5.75% by July 2023. The peak rate assumptions also moved closer to the range of 5.75% to 6.00%.

   

• Till early February, there were strong expectations of a rate cut in the second half of 2023. Now it looks very likely that rate cuts may happen in 2024, instead of 2023. There is just an outside probability of rate cuts in 2023.

   

• With Fed rates currently in the range of 4.50% to 4.75%, the markets are pencilling in additional rate hikes of 75-100 bps in a likely scenario and 100-125 bps in a worst case scenario. Which means; rates could scale closer to 6%, or even beyond.

   

• It is back to front-ending with a strong probability that the March Fed meet may see a rate hike of 50 basis points instead of 25 bps. This is likely to be followed by another 2 or 3 round of 25 bps each.

Fedwatch is clearly factoring in higher terminal rates and also more front ending of rate hikes in the first half of 2023; in a clear market vote for hawkishness.

What we read from the February 2023 FOMC minutes

Broadly, members of the FOMC are still committed to bringing down the pace of rate hikes. However, February FOMC minutes betray a sense of urgency in front-ending rate hikes. All members of the FOMC have hinted at “curbing unacceptably high inflation” as a key monetary policy mission. Here is what we read from the FOMC minutes for February 2023.

1. The gist of the policy minutes was that Fed rates will have to move higher and rate hikes may once again be front-ended. Going ahead, the intent of the Fed would be to limit the rate hikes from this point, although there is no clarity on the terminal rates. From the data available, the terminal rates appear to gravitate towards 6%.

    

2. The members of the FOMC have specially taken note of the upside risks to the inflation outlook, considering the risks to the food basket and the fuel basket. US has seen core inflation coming down progressively, although it still remains well above 5%. FOMC members concurred that the focus on path to 2% will not be compromised. 

    

3. Despite inflation touching 40-year highs and down just marginally, there was only a minority in favour of front ending of rates. However, the Fed may veer towards a front-ending of 50 bps rate hike in the March meeting to ensure that short term consumption driven inflation pressures are kept at bay.

    

4. In the February meeting of the Fed, the terminal rate of inflation based on the dot plot chart had moved up from 5.1% to 5.6%. Now even that does not look too realistic. It appears that the March 2023 Fed policy could see the terminal Fed rates moving decisively towards 6% or marginally above that.

    

5. That brings us to the recession risk in the US economy. To avoid too much speculation on recession, FOMC avoided specific talk on terminal rates. But the markets have manifested this risk in spike in bond yields. Recession remained a concern with members pointing to sharp fall in consumer spending since 2022. However, savings and budget surpluses were offsetting forces.

    

6. One of the factors standing between rate hikes and inflation control appears to be strong labour data. The US economy is adding jobs at a record pace and that is buffering most of the rate hike impact. The result is that inflation is 2.5 times the target for January and that can be largely attributed to robust jobs data.

    

7. More than the data, it is often the perception or the assumptions that matter. The minutes reveal that Fed officials are still attuned to the risk they may have to do a lot more to keep inflation falling. The Committee feels that giving up on hawkishness at this point would not only compromise the fight against inflation, but also raise inflation expectations among consumers.

Clearly, hawkishness of the Fed is not going away in a hurry, and that appears to be the singular message from the Fed minutes.

What do the Fed minutes mean for India?

Interestingly, the Fed minutes came on the same day that the MPC minutes were announced by the RBI and the undertone was also the same. Both the RBI and the Fed are unwilling to give up on hawkishness. Here are 3 key takeaways for India.

• It looks like hawkishness is here to say, at least, till inflation shows a decisive move downward. In India, the impact is visible in WPI inflation but not in CPI inflation.

   

• Indian corporate balance sheets are more vulnerable to funding costs as we saw in Q3FY23. More hawkishness would only mean more pressure on operating margins.

   

• The good thing is that the RBI MPC is now getting increasingly divided in its opinion. Rates is what the government and RBI can control and that is what they must do. The focus must be to ensure that the cost of funds do not got out of hand, to the detriment of corporate profit margins.

The impact on Indian markets is visible. Too much hawkishness has not gone down well. It is now over to the fiscal hints from the government to offset this hawkish narrative.