8 mins read . 18 Jul 2023
There was not much of a surprise in the Fed deciding to pause on rates on the June 2023 meeting. That was already hinted by Jerome Powell and the rate pause was called for after 10 consecutive rate hikes in the US by the Fed. In fact, rates in the US had gone up by 500 basis points between March 2022 and May 2022. It had actually traversed from the range of 0.00%-0.25%, all the way to 5.00%-5.25%. Over a period of 15 months, the Fed had hiked rates 10 times. The idea was the singular pursuit of inflation control. The next meeting of the Fed comes up on July 26, 2023. The Fed has been all along indicating that there would be a 25 bps rate hike in July. However, with inflation for June 2023 coming sharply lower at 3%, the question is where there is an urgency for the Fed to cut rates. We will read the indications coming from 3 sides; the CME Fedwatch, June Fed Minutes and June Inflation.
One way to understood what the Fed will do is to study the CME Fedwatch. Now, the CME Fedwatch captures the probabilities of different rate levels after each Fed meet over the next 1 year. What is interesting is that these probabilities are derived from the Fed Futures prices, so it is the best consensus of what the markets are expecting.
Data source: CME Fedwatch
The CME Fedwatch probabilities must always be seen in the perspective of how it evolved over time. If one were to compare the probabilities with about a week back, then there are some few clear changes. Firstly, the move has been definitely less hawkish and markets are expecting the Fed to stop at 25 bps higher. In fact, there is a high probability of 95% that there will be a rate hike in July itself. That means, the July 2023 rate hike of 25 bps may be the last rate hike in this round and then the rates may either stay static or may go down over time. That is unless the inflation monster really scales up from the current levels. This shift has specifically happened after the consumer inflation in the US for the month of June fell sharply by 100 bps to 3%.
Before we look at the FOMC minutes, it must be remembered that the minutes were announced prior to the latest inflation number of 3% announced. Hence, the FOMC minutes would only reflect the last inflation figure of 4% announced for May 2023. FOMC members were quite clear that further policy tightening was not only likely, but also essential to bring inflation fully under control. However, what the Fed minutes also indicated was that the rate hikes would be more calibrated. That means, the Fed would not be in a hurry to front-end rate hikes but would purely go by how the data evolves.
While the Fed minutes also hinted at a high probability of a 25 bps rate hike in July 2023, the journey after that was not too clear. Obviously, the members of the Fed did not share the same level of hawkishness as made out by Jerome Powell in his speeches. The two major targets of monetary policy were controlling inflation and not upselling the jobs applecart. At the current level, both have been substantially achieved, hence the Fed minutes also indicate that after the July rate hike, the journey may be data driven. With the latest inflation number at 3%, fewer rate hikes in the future look more likely.
For the month of June 2023, the US consumer inflation fell to 3%. This is the lowest since March 2021. It represents a fall of 100 bps in the last one month and 190 bps in the last 2 months. Now, inflation in the US has fallen 610 bps from the June 2022 peak levels of 9.1% and is just about 100 bps away from the Fed’s eventual target of 2% inflation. The fall in inflation has also been across the board with food inflation falling 100 bps, energy inflation falling 500 bps and core inflation also falling by 50 bps. If you go by the inflation data and the gist of the minutes, there is room for the Fed to pause in July always. However, the market indicator, CME Fedwatch is hinting at a 25 bps rate hike in July. So, the most likely scenario is a 25 bps hike in July and a pause after that.
With the RBI already on pause mode since its last rate hike in February, it would be closely watching the Fed policy statement on July 26, 2023. The July Fed policy could actually pose a dilemma for the RBI. Between May and June, India inflation went farther from its target while the US inflation has gone closer to its target. If the Fed holds rates, the RBI may not be too worried and would actually celebrate. However, if the Fed hikes rates by 25 bps, then the RBI would have to quickly take a call on possible monetary divergence. That would be an interesting situation.