The Fed Meeting - June 2022
A few updates and thoughts on the FOMC meeting
That was quite the surprise we got from the Fed yesterday.
The Fed raised the Fed Funds rate by 75bps (0.75%) on June 15, 2022 - the largest hike since 1994. This comes despite previous discussion from Fed Chair Powell that 75bps was not on the table. But, inflation is high on the agenda and the Fed Chair opened with these remarks.
The pivot was definitely surprising and what’s more surprising is that they are not dismissing a further hike of 75bps, should it be required.
There was no discussion to changes in the Quantitative Tightening, i.e., reduction in the balance sheet, which technically started yesterday.
Here’s a few thoughts on the announcement, and the press conference.
Fed Chair Powell has always been quite methodical in his approach and has always leaned towards being dovish. While he has increasingly become hawkish over the last few months, deviating from his previous statements and surprising the market with 75bps hike was not something that I had expected. But, now we have it and let’s see what’s next.
This tight labor market sets the stage for the Fed to tighten aggressively:
Labor demand has been strong but supply has still be low. But, the FOMC members expect demand and supply to come into balance, easing the upward pressure on wages and prices. (Supposedly!)
There is a record number of job openings. Unemployment rate is at a 50-year low. Labor force participation rate remains largely unchanged from January.
The Fed’s previous estimate of unemployment has already increased from 3.7% to 4.1% in 2024, levels above the March projections. But, with the path the Fed has taken for tightening, I wouldn’t be surprised if the Fed allows the unemployment rate to rise further than that, to combat inflation. I can see unemployment going to even 7%, as a result of a “do-whatever-it-takes” policy. I hope I am wrong.
The Dot Plot
The Federal Funds rate now stands at 1.5% to 1.75%. If we look at the dot plot, the median from FOMC members stands at 3.40% by the end of 2022 and 3.8% by the end of 2023. If you take an average of these estimates, we are about 2% away from where they are indicating.
How high does the rate need to go? According to the Fed, perhaps somewhere around 3.5%-4%. So that takes us to another 2.5% in rate increases from now until 2023. We will see if this indeed makes a dent to the level of inflation and if they can actually increase to that level.
The Fed acknowledged that inflation is running hot and that was their reason for the upside surprise in rates. They acknowledged the CPI data, the geopolitical situation in Europe and lockdowns in China would continue to put pressure on supply chains while demand remains strong.
The PCE inflation forecast by FOMC members is 5.2% by the end of 2022, 2.6% by the end of 2023 and 2.2% by the end of 2024. These forecasts are overly optimistic, at least for 2022 and 2023.
Supply chain disruptions are not abating as Covid still plagues many parts of the world; not to mention there is no resolution in sight for the Russia - Ukraine situation. While the US administration is making attempts at bringing energy prices down, they seem to have a confused agenda on how to go about this.
The Fed discussed continuing measures until they reach their target inflation rate of 2%. This is quite unlikely to happen. But, even if they keep tightening until they reach 4%-5%, we’re likely to have more pain in the economy and definitely a recession.
GDP and Recession
Real GDP Growth forecasts were tempered down to below 2% by the FOMC members through to 2024. The Fed continues to say that the American economy is strong and can handle monetary policy.
Fed Chair Powell was very forceful in his assessment that consumer spending remains strong and there is no major slowdown in the economy. I suppose they did not see the Retail Sales report that came out the earlier in the day showing a decline for the first time in the year.
The Atlanta Fed Nowcast model however, is already predicting a 0% growth for Q2, 2022 and this puts the US into a technical recession.
But, regardless of what the statistics say, the financial conditions in the US have tightened to the point where it’s already exhibiting signs of a recession:
Stocks are in a bear market
Credit spreads are blown out and the bond market has seen an epic rout
Mortgage rates are rising fast enough to break the housing market
The financial conditions we are seeing right now, has almost always been followed by the Fed loosening monetary policy, injecting funds into the economy and cutting rates.
The decline of liquidity in the economy and the increase in rates, will restrict flows to businesses and the consumer at a time when they are already battling high prices from inflation. And inflation will remain upward sticky for a while.
Not to mention, cutting costs will also mean an increase in unemployment as we’re already seeing happen with even the biggest companies.
So the consumer and businesses will be hit by a double whammy and we are like to see a protracted bear market and prolonged weakness in the economy.
The Stock Market
As far as the market is concerned, trading on Fed day is always tricky. We saw a pop once the announcement was made. Call it a relief rally, call it short covering, call it people taking off their hedges but, it was just a knee-jerk reaction. As of the writing of this newsletter, the S&P has now given up all its gains from yesterday.
With higher rates and decreasing liquidity, it stands to reason that we still remain in a bear market with violent rallies because lower liquidity will also exacerbate volatility.
This time the Fed is tightening into a serious slowdown of the economy with seriously tough financial conditions. I don’t mean to call for gloom and doom but, challenging times are ahead.
Ayesha Tariq, CFA
There’s always a story behind the numbers