The Fed stops dithering. So OK, maybe no soft landing. Markets alone

Things are moving fast now, but the Fed continues to add fuel to the fire.

By Wolf Richter for WOLF STREET.

Struggling to restore its shredded and ridiculed credibility as an inflation fighter, the Fed today wrapped up the most hawkish Fed meeting in decades. Following last week’s CPI report, which apparently blew every doorknob inside the Fed’s Eccles Building, everything went up a heap: real policy rates, policy rates by the end of 2022 and 2023, projected inflation rates and projected unemployment rates. . The only thing that has been lowered is the economic growth projection.

The FOMC voted to raise all policy rates by 75 basis points, the most hawkish move since 1994, with only one dissenting vote (from Esther George, who wanted a 50 basis point hike) :

  • Target range for federal funds rates, between 1.50% and 1.75%.
  • The interest it pays to banks on reserves, at 1.65%.
  • Get interested charges on day-to-day pensions, at 1.75%.
  • Get interested pay on overnight Reverse Repos (RRP), at 1.55%.
  • Primary credit rate it charges banks, at 1.75%.

“Obviously, today’s 75 basis point increase is unusually large, and I don’t expect moves of this magnitude to be common,” Fed Chairman Jerome said. Powell, in his statement at the press conference. But he said at the next meeting in July, another 75 basis point hike could be on the table.

And the Fed will “seek compelling evidence” that inflation is falling before “declaring victory,” Powell said. This phrase, “irrefutable evidence,” has cropped up a lot recently among Fed governors. They look for more than a little squiggle in the line before backing off.

Expects much higher, much faster policy rates.

This is now changing rapidly. Today’s ‘dot plot’ in Economic Materials showed that the 18 FOMC members who attended the meeting expected the Fed to raise its federal funds rate to at least 3% by the end of 2022, 13 members expecting higher rates. The median projection jumped to 3.4%.

The Fed is expected to raise its key rates an additional 1.75 percentage points to reach the median projection of 3.4% by the end of this year.

The median projection for the policy rate at the end of 2023 has risen to 3.8%. For 2024, it has dropped to 3.4%.

Those 3% to 4% policy rates were unbelievably and unbelievably high just a few months ago. It was something the Fed would never and could never do because of anything. Now they are on the table.

Quantitative tightening (QT) has started.

QT started this month. The plan was presented in May. The Fed confirmed today that it is proceeding as planned. During the June-August transition period, the Fed caps the amount of securities that can exit the balance sheet at $47.5 billion per month ($30 billion in Treasuries, $17.5 billion in MBS ). From September, the caps will double to a total of $95 billion per month.

If there are not enough Treasuries and bonds maturing during the month to reach the cap, the Fed will make up the difference by allowing short-term Treasuries to mature without replacement. . In other words, the cap is essentially a fixed amount that will come off the balance sheet.

The Fed will not outright sell securities at this point, but will allow them to mature without replacement. Most of the discounts for MBS will come from principal payments passed on to MBS holders when mortgages are paid off (when the house is sold or the mortgage is refinanced) or are paid off through regular mortgage payments.

Always pour oil on the fire.

With the Fed’s target range for the federal funds rate being between 1.50% and 1.75%, the effective federal funds rate (EFFR) will be around 1.6% going forward.

But CPI inflation is now 8.6%, and the “real” EFFR is now a negative 7%, which is the amount by which the Fed has lagged inflation. Its slowness to react to inflation is unprecedented in modern times:

Say goodbye to “labour shortage”.

Higher interest rates are supposed to slow demand, which is supposed to take some fuel out of runaway inflation. Due to lower demand, unemployment is expected to rise.

The Fed raised its unemployment rate projections, with the median projection rising from 3.7% at the end of 2022 to 3.9% at the end of 2023 and 4.1% at the end of 2024.

This is the first time in this cycle that the Fed expects unemployment to rise due to its repression of inflation. In the May meeting statement, the Fed still expected its magic to bring inflation back to its 2% target, while the labor market remained strong. This line went out the window in today’s statement.

And Powell confirmed at the press conference that the Fed is unlikely to be able to bring inflation down to 2% without deliberately slowing the economy and increasing unemployment.

Rising unemployment would obviously end the “labour shortage” and unravel some of the inflation and supply chain issues that came with it.

Expects higher inflation rates.

The Fed has been ridiculously far behind reality for the past 15 months in its projection of inflation rates. But he raised them, and today he has taken them further. His median projection for the PCE inflation rate has risen to 5.2% by the end of 2022. But he still hopes that by the end of 2023 the PCE inflation will be down to 2.6. % and that by the end of 2024 it will be reduced to 2.2%.

But that projection could also fade as “participants continue to see inflation risks as weighted to the upside,” Powell said at the press conference.

Expects an economic slowdown: Avoiding a recession “is not going to be easy”.

The idea is to slow demand growth by a certain amount, just enough to lower inflation, but not enough to trigger a recession. But achieving that soft landing under current conditions “doesn’t get any easier,” Powell said.

“What’s becoming clearer is that many factors that we don’t control are going to play a very big role in deciding whether it’s possible or not,” he said. “It won’t be easy.”

“The events of the past few months have increased the degree of difficulty” in getting that soft landing, he said. “It’s much more likely now that it depends on factors that we don’t control. Fluctuations and spikes in commodity prices could end up taking that option away from us. »

He thus implicitly recognized that the risk of recession would be the price to pay to reduce this galloping inflation.

Expects markets to determine their own landing.

After past sales of around 20% of the S&P 500, the Fed would start putting phrases in its communications that indicated some sort of pivot. It was the Fed’s put option. But that, too, went out the window. The S&P 500 is down 21% from its high, and the Nasdaq is down 31%, and yet none of this suggests the Fed is worried.

On the contrary. The market sell-off, if it continues, and the sustained decline in prices in the housing market, could do the heavy lifting for the Fed, so the Fed may not have to raise its policy rates towards the benchmark rate. inflation, or even above. the inflation rate – above the red line on the EFFR-CPI chart – to bring inflation down, which would be a real carpet for the economy. It looks like the markets are going to have to figure out how to fend for themselves in the face of rising interest rates and QT.

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