US Fed minutes hint more rate hikes but at slower pace

US Federal Reserve officials saw little evidence late last month that US inflation pressures were easing and steeled themselves to force the economy to slow down to control an ongoing surge in prices, according to the minutes of their July 26-27 policy meeting.

While not explicitly hinting at a particular pace of coming rate increases, beginning with the September 20-21 meeting, the minutes released on Wednesday showed US central bank policymakers committed to raising rates as high as necessary to tame inflation - even as they began to acknowledge more explicitly the risk they might go too far and curb economic activity too much.

"Participants agreed that there was little evidence to date that inflation pressures were subsiding," the minutes said.

Though some reduction in inflation, which has been running at four-decade highs, might occur through improving global supply chains or drops in the prices of fuel and other commodities, much of the heavy lifting would have to come by imposing such high borrowing costs on businesses and households that they would spend less, the minutes stated.

"Participants emphasized that a slowing in aggregate demand would play an important role in reducing inflation pressures," the minutes said.

Yet despite that arch tone on inflation as their top concern, the minutes also flagged what will be an important dimension of the Fed's debate in coming months - when to slow down the pace of rate increases, and how to know if rate hikes have gone past the point needed to beat rising prices.

While judged as generally dovish by traders who increased their bets the Fed would approve just a half-percentage-point hike at the September meeting, Bob Miller, Head of Americas Fundamental Fixed Income at BlackRock, said the minutes seemed to be giving the Fed more scope to react as data flowed in.

"The intended message was much more nuanced and reflected a need to optionality by a central bank trying to assess conflicting economic data and shocks”, he said. "Staking out some conditionality going forward seems sensible given the unprecedented nature of this particular cycle."

The pace of rate increases indeed could ease as soon as next month, with the minutes stating that, given the need for time to evaluate how tighter policy is affecting the economy, it would become appropriate at some point to move from the large, 75-basis-point increases approved at the Fed's June and July meetings, to half-percentage-point and eventually quarter-percentage-point hikes.

Some participants said they felt rates would have to reach a sufficiently restrictive level and remain there for some time in order to control inflation that was proving far more persistent than anticipated.

Many, on the other hand, noted the risk that the Fed could tighten the stance of policy by more than necessary to restore price stability, particularly given the length of time it takes for monetary policy to change economic behavior.

Referring to the rate increases already telegraphed by the Fed, participants generally judged that the bulk of the effects on real activity had yet to be felt, the minutes stated.

As of the July meeting, Fed officials noted that while some parts of the economy, notably housing, had begun to slow under the weight of tighter credit conditions, the labor market remained strong and unemployment was at a near-record low.

The Fed has lifted its benchmark overnight interest rate by 225 points this year to a target range of 2.25% to 2.50%. The central bank is widely expected to hike rates next month by either 50 or 75 basis points.

For the Fed to scale back its rate hikes, inflation reports due to be released before the next meeting would likely need to confirm that the pace of price increases was declining. Inflation by the Fed's preferred measure is more than three times the central bank's 2% target.

Data since the Fed's July policy meeting showed annual consumer inflation eased that month to 8.5% from 9.1% in June, a fact that would argue for the smaller 50-basis-point rate increase next month.

But other data released on Wednesday showed why that remains an open question.

Core US retail sales, which correspond most closely with the consumer spending component of gross domestic product, were stronger than expected in July. That data, along with the shock-value headline that inflation had passed the 10% mark in the United Kingdom, seemed to prompt investors in futures tied to the Fed's target policy interest rate to shift bets in favor of a 75-basis-point rate hike next month.

Meanwhile, a Chicago Fed index of credit, leverage and risk metrics shows continued easing. That poses a dilemma for policymakers who feel that tighter financial conditions are needed to curb inflation.

Job and wage growth in July exceeded expectations, and a recent stock market rally may show an economy still too hot for the Fed's comfort.

 

 

Can emerging markets cope with the shift in US Fed policy?

For most of last year, investors priced in a temporary rise in inflation in the United States given the unsteady economic recovery and a slow unraveling of supply bottlenecks. Now sentiment has shifted. Prices are rising at the fastest pace in almost four decades and the tight labor market has started to feed into wage increases.

According to a report by International Monetary Fund (IMF), the new Omicron variant has raised additional concerns of supply-side pressures on inflation. The US Fed referred to inflation developments as a key factor in its decision last month to accelerate the tapering of asset purchases.

Inflation is likely to moderate later in year 2022 as supply disruptions ease and fiscal contraction weighs on demand. The Fed’s policy guidance that it would raise borrowing costs more quickly did not cause a substantial market reassessment of the economic outlook.

The history shows that the effects on emerging markets benign if tightening is gradual, well telegraphed, and in response to a strengthening recovery. Emerging-market currencies may still depreciate, but foreign demand would offset the impact from rising financing costs.

Spillovers to emerging markets could also be less benign. Broad-based US wage inflation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation. Faster Fed rate increases in response could rattle financial markets and tighten financial conditions globally.

These developments could come with a slowing of US demand and trade, which may lead to capital outflows and currency depreciation in emerging markets.

The impact of Fed tightening in a scenario like that could be more severe for vulnerable countries. In recent months, emerging markets with high public and private debt, foreign exchange exposures, and lower current-account balances saw already larger movements of their currencies relative to the USD.

The combination of slower growth and elevated vulnerabilities could create adverse feedback loops for such economies, as the IMF highlighted in its October 2021 releases of the World Economic Outlook and Global Financial Stability Report.

Some emerging markets have already started to adjust monetary policy and are preparing to scale back fiscal support to address rising debt and inflation. In response to tighter funding conditions, emerging markets should tailor their response based on their circumstances and vulnerabilities.

Those with policy credibility on containing inflation can tighten monetary policy more gradually, while others with stronger inflation pressures or weaker institutions must act swiftly and comprehensively.

In either case, responses should include letting currencies depreciate and raising benchmark interest rates. If faced with disorderly conditions in foreign exchange markets, central banks with sufficient reserves can intervene provided this intervention does not substitute for warranted macroeconomic adjustment.

Nevertheless, such actions can pose difficult choices for emerging markets as they trade off supporting a weak domestic economy with safeguarding price and external stability. Similarly, extending support to businesses beyond existing measures may increase credit risks and weaken the longer-term health of financial institutions by delaying the recognition of losses. And rolling back those measures could further tighten financial conditions, weakening the recovery.

To manage these tradeoffs, emerging markets can take steps to strengthen policy frameworks and reduce vulnerabilities. For central banks tightening to contain inflation pressures, clear and consistent communication of policy plans can enhance the public’s understanding of the need to pursue price stability.

Countries with high levels of debt denominated in foreign currencies should look to reduce those mismatches and hedge their exposures where feasible. And to reduce rollover risks, the maturity of obligations should be extended even if it increases costs. Heavily indebted countries may also need to start fiscal adjustment sooner and faster.

Continued financial policy support for businesses should be reviewed, and plans to normalize such support should be calibrated carefully to the outlook and to preserve financial stability. For countries where corporate debt and bad loans were high even before the pandemic, some weaker banks and nonbank lenders may face solvency concerns if financing becomes difficult. Resolution regimes should be readied.

Beyond these immediate measures, fiscal policy can help build resilience to shocks. Setting a credible commitment to a medium-term fiscal strategy would help boost investor confidence and regain room for fiscal support in a downturn. Such a strategy could include announcing a comprehensive plan to gradually increase tax revenues, improve spending efficiency, or implement structural fiscal reforms such as pension and subsidy overhauls (as described in the IMF’s October Fiscal Monitor.

Finally, despite the expected economic recovery, some countries may need to rely on the global financial safety net. That may include using swap lines, regional financing arrangements, and multilateral resources. The IMF has contributed with last year’s US$650 billion allocation of Special Drawing Rights, the most ever.

While such resources boost buffers against potential economic downturns, past episodes have shown that some countries may need additional financial breathing room. That’s why the IMF has adapted its financial lending toolkit for member nations.

Countries with strong policies can tap precautionary credit lines to help prevent crises. Others can access lending tailored to their income level, though programs must be anchored by sustainable policies that restore economic stability and foster sustainable growth.

While the global recovery is projected to continue this year and next, risks to growth remain elevated by the stubbornly resurgent pandemic. Given the risk that this could coincide with faster Fed tightening, emerging economies should prepare for potential bouts of economic turbulence.

US Fed decision to tapper asset purchase a nonevent

For the first time since the pandemic began, the US Federal Reserve will reduce the stimulus they provided during COVID-19 crisis. Given the significance of this move and what it means for the central bank’s economic outlook, greenback should be trading much higher.

However, there’s been very little demand for the greenback over the past two weeks because the Fed has done an effective job of preparing the market for the imminent change. They’ve been talking about reducing or tapering asset purchases for the past few months giving investors plenty of time to position for the move. Bond yields soared and USD/JPY rose to its strongest level in 3 years just under two weeks ago but since then, we’ve seen more consolidation than continuation.

The decision to taper won’t be the most market moving one on Wednesday. Instead, investors want to know when taper will end and rate hikes begin. Fed Chairman Powell previously said taper could be finished sometime around the middle of next year. A precise end date will be positive for greenback, although it could also be calculated by the amount of bond purchases cut per month.

For example, if they reduce bond purchases by US$15 billion a month starting November, they could be done buying bonds by June 2022. Any number larger than US$15 billion (between Treasuries and mortgage backed securities) would be considered aggressive and anything smaller would be considered conservative.

The larger the reduction, the more upside pressure for the greenback and downside pressure for stocks. With the housing market refusing to cool, the Fed is unlikely to go for a smaller move but based on the new highs in stocks, investors also don’t expect significant hawkishness.

The Fed will be reluctant to make any commitments about rate hikes. Powell will almost certainly downplay the need to change interest rates but investors will make their own assumptions based upon how much they cut asset purchases and what he says about inflation.

CPI growth is at a 30 year high but core PCE, retail sales, non-farm payroll growth and ISM manufacturing declined from the previous month. Right now, there’s a significant misalignment between investor expectations and Fed guidance. None of the members of the FOMC expect rates to rise in 2022 but the market is pricing in over 50bp of tightening in year 2022. 

If the Fed fans those expectations by suggesting that prices are less transitory (or that word disappears completely), the greenback will rise but if they don’t waver from their view that prices will fall, the disappointment will send EUR/USD and USD/JPY plunging. 

Before FOMC, ADP and ISM services, two important leading indicators for Friday’s non-farm payrolls report will be released, making it a very insightful day for the greenback.