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Summary

The 75 bps rate hike by the FOMC today—the largest in 27 years—demonstrates the Committee’s growing concern over inflation as well as its increased commitment to restore price stability. The move takes the fed funds rate to a range of 1.50-1.75%, which is still below the Committee’s estimated range of neutral.

The statement and updated Summary of Economic Projections (SEP) showed the FOMC is prepared to continue to tighten policy at a historically aggressive pace. The median estimate for the fed funds rate at year-end rose to 3.375%, implying another 175 bps of tightening before the year is over.

Despite aiming to move policy into restrictive territory by year-end, the SEP continues to paint a rather optimistic picture of the economy ahead. GDP growth next year is expected to slow only slightly below trend, while inflation falls back to 2-3% and the unemployment rate rises modestly enough to where it remains within its "longer-run" neutral range. In our view, it will take a more material slowdown in economic growth to bring core inflation back to the FOMC's 2% target and more damage is likely to be inflicted to the labor market.

Historic Inflation Requires a Historic Response

Growing alarm over inflation led the Federal Open Market Committee (FOMC) to deliver its biggest rate increase in 27 years at today's meeting. Specifically, the FOMC voted to raise the fed funds rate 75 bps, bringing the target range to 1.50-1.75%. In the post-meeting release, the Fed underscored its focus on inflation by adding the statement that "the Committee is strongly committed to returning inflation to its 2% objective." Yet, the Fed appears to be increasingly aware that this objective will not be quick or easy. The statement removed the line that "the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong", a tacit admission that reining in inflation will likely inflict some pain on the labor market.

The historically large rate hike comes as inflation shows no signs of abating soon. Following the last FOMC meeting in early May, Chair Powell pledged to be nimble if price pressures did not ease as anticipated. Since then, both the April and May CPI reports came in hotter than expected, with "peak" inflation increasingly likely to still be ahead. At the same time inflation concerns have intensified, the labor market has remained on fire. Job growth surprised to the upside in the two employment reports since the FOMC's last meeting, and labor demand is still exceptionally strong. However, not all Committee members were on board with such an aggressive and, up until a few days ago, unanticipated response. Kansas City Fed President Esther George, historically one of the more hawkish members of the Committee, dissented in favor of a smaller 50 bps hike.

The statement released by the Committee at today's meeting made clear that "ongoing increases in the target range [for the federal funds rate] will be appropriate." The median projection in the dot plot was for the federal funds rate to finish 2022 at 3.375% which would suggest 175 bps of additional tightening at the remaining four FOMC meetings of the year. This could imply the FOMC reverts back to 50 bps for most of the remaining meetings of the year or opts for another 75 bps in July and then steadily ramps the pace back down to 50 bps and then 25 bps.

For 2023, the median dot for year-end was 3.75%. It is important to bear in mind that the projections for the dot plot are for the year-end federal funds rate. Thus, it is possible some participants expect the rate to peak somewhat higher than 3.75% at some point next year before reversing course. Regardless, it is clear that the baseline expectation on the Committee is for the bulk of the rate hikes to occur in 2022. In 2024, the median projection falls slightly to 3.375%, in line with inflation that continues to gradually normalize.

Although it did not play a major role in the statement or Chair Powell's press conference, the Fed's balance sheet began to decline this month and will continue to do so for the foreseeable future. The Federal Reserve will allow up to $30 billion worth of Treasury securities to roll off the central bank's balance sheet each month from June through August. The Fed will also allow up to $17.5 billion worth of mortgage-backed securities to roll off the balance sheet per month. The FOMC's plan is then to increase the size of the monthly caps to $60 billion and $35 billion, respectively, beginning in September, and to maintain the monthly caps at those levels for an indefinite period of time.

In the post-meeting press conference, Chair Powell made clear that the Committee does not expect 75 bps rate hikes to be "common." That said, his comments made clear that another 75 bps rate hike could come in July depending on how the data evolve over the next six weeks. This suggests to us the July 13 CPI release for June will be critical to the Committee's decision on the fed funds rate at the next meeting. Chair Powell once again reiterated that the Committee needs to see "compelling" evidence that inflation is rolling over before it feels comfortable taking its foot off the brake.

Starting to—But Not Fully—Fessing Up to Pain Ahead

We believe the SEP paints a more realistic but still overly optimistic picture of the bumpy road ahead for the economy as the Fed aims to restore price stability compared to the March projections. Inflation is still expected to run at an elevated rate over the next year-and-a-half, consistent with the more aggressive policy path outlined by the dot plot. The median estimate for headline PCE inflation in Q4 was revised up to 5.2% from 4.3%, while core PCE expectations were bumped up to 4.3%. While inflation is expected to recede over 2023, Committee members look for inflation to remain noticeably above target; the median estimate puts headline PCE at 2.6% in Q4:2023 and core at 2.7%, both little changed from the March projections. Notably, no Committee members expect core inflation to fall back below 2% through 2024.

Meanwhile, officials expect the tighter policy to have only a modestly more dampening effect on economic growth. The median estimate for GDP Q4/Q4 GDP growth in 2022 was downwardly revised to 1.7% from 2.8% in the March projections. GDP forecasts for 2023 were also pared down, but at 1.7% show the FOMC expects the economy to grow closely in line with its longer-run rate of 1.8%. This slowdown in economic growth was reflected in the projections for the unemployment rate. The median forecast for the unemployment rate shows a steady rise from 3.7% at the end of this year to 3.9% at the end of 2023 and 4.1% at the end of 2024. An unemployment rate of 4.1% is not far off the Committee's "longer-run" neutral estimate of 4.0%, and it is indicative of a very soft landing for the economy, or "masterful performance" in the words of Federal Reserve Governor Waller. That said, unemployment that is increasing by more than half a percentage point as a base case scenario highlights the potential risks of a harder landing. In our view, it will take a more material slowdown in economic growth to bring core inflation back to the FOMC's 2% target.

Taking a step back, we believe today's 75 bps rate hike marks an important inflection point in U.S. monetary policy. Numerous Fed officials have stated previously that monetary policy should be nimble in response to new developments and that the FOMC will do whatever it takes to reduce inflationary pressures. Prior to last Friday's CPI report, consensus expectations were firmly anchored to a 50 bps rate hike. But after the inflation data came in hotter than expected, it appears the Committee nimbly adjusted course in real time. Ultimately, the difference between 50 and 75 bps is somewhat small, but today's hike boosts the Fed's credibility and demonstrates that the door is open for similar adjustments at future meetings. This suggests to us a much more sensitive reaction function from the FOMC, and similar upside inflation surprises in the future very well may be met with equally aggressive upside surprises for the federal funds rate.

Key takeaways

• As expected, the Fed hiked the target range by 75bp to 1.50-1.75% and left the QT programme unchanged.
• Fed Chair Jerome Powell mentioned that the Fed can hike by another 75bp in July but that we should not expect a series of 75bp rate hikes. This sounds very similar to the May meeting when Powell mentioned that the committee was not "actively considering" 75bp. As long as inflation remains high, the Fed is forced to deliver.
• We change our Fed call now expecting the Fed to hike by 75bp in July and 50bp in September, November and December. If we are right, the Fed funds target range would be 3.75-4.00% by year-end (vs. Fed dot of 3.375% and market pricing of 3.5%).
• We still see risks skewed towards faster and more tightening given the inflation outlook. Our base case is that the US falls into a recession in Q2 23 but the faster hiking pace increases the risk that it starts earlier.
• FX: We expect the Fed to underpin our forecast for seeing EUR/USD towards parity in 12M.
• FI: We see upside risks to our UST 10yr yield target of 3.50% in 3-6M.

Full report in PDF.

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The Federal Reserve Open Market Committee (FOMC) lifted the federal funds rate to the 1.5% to 1.75% range and announced a continuation of its balance sheet runoff.

The Fed updated its language to reflect greater economic momentum, stating that "overall economic activity appears to have picked up after edging down in the first quarter. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures."

The Fed's Summary of Economic Projections was updated from March:

• The median projection for real GDP growth was downgraded in 2022 (1.7% from 2.8%). The forecast for 2023, 2024, and the longer run came in at 1.7%, 1.9%, and 1.8% (from 2.2%, 2.0%, and 1.8%), respectively.
• The median unemployment rate forecast 3.7% (3.5%) for 2022, 3.9% (3.5%) for 2023, and 4.1% (3.6%) in 2024. The longer-run estimate of the unemployment rate stayed the same at 4.0%.
• On inflation, the median estimate for core PCE was assumed to be 4.3% in 2022, 2.7% in 2023, and 2.3% in 2024.
• The median projection for the fed funds rate was lifted to 3.4% in 2022, 3.8% in 2023, and 3.4% in 2024. The long-run neutral rate was assumed to be 2.5%.

All of the members of the FOMC voted in favor of the decision, except Esther George who preferred a 50 basis point hike.

Key Implications

The Fed put the pedal to the metal on its rate hiking cycle, as inflation shows no signs of abating. Fed members upgraded their outlook for near-term inflation, which coincided with a big increase in their expectations for the path of the fed funds rate over this year and next.

This decision was expected by markets, but the increase in members' willingness to hike rates well beyond neutral over the next few meetings is undoubtedly hawkish. This closely aligns with market pricing over the rest of 2022, justifying the level of U.S. Treasury yields, which have converged around the 3.5% level.

https://www.youtube.com/watch?v=Azr9FRuFED0

Fed hikes by 75bps to 1.50-1.75%. Esther George dissented and voted for a 50bps hike only. Fed said that it's "highly attentive to inflation risks" in the statement. Also, Fed now forecasts interest rate to be at 3.4% by the end of this year, sharply higher than prior estimate of 1.9%. Also, in the new dot plot, all members penciled in rate hikes to 3.125% and above by the end of 2022.

In the new median economic projections, federal funds rate is forecast to be at:

• 3.4% by the end of 2022 (up from 1.9%)
• 3.8% by the end of 2023 (up from 2.8%)
• 3.4% by the end of 2024 (up from 2.8%)

GDP growth is forecast to be at:

• 1.7% in 2022 (down from 2.8%)
• 1.7% in 2023 (down from 2.2%)
• 1.9% in 2024 (down from 2.0%)

PCE inflation is forecast to be at:

• 5.2% in 2022 (up from 4.3%)
• 2.6% in 2023 (down from 2.7%)
• 2.2% in 2024 (down from 2.2%)

Core PCE inflation is forecast to be at:

• 4.3% in 2022 (up from 4.1%)
• 2.7% in 2023 (up from 2.6%)
• 2.3% in 2024 (unchanged).

Unemployment rate is forecast to be at:

• 3.7% in 2022 (up from 3.5%)
• 3.9% in 2023 (up from 3.5%)
• 4.1% in 2024 (up from 3.6%)

Full statement here.

New economic projections

Overall economic activity appears to have picked up after edging down in the first quarter. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.

The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The invasion and related events are creating additional upward pressure on inflation and are weighing on global economic activity. In addition, COVID-related lockdowns in China are likely to exacerbate supply chain disruptions. The Committee is highly attentive to inflation risks.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 1‑1/2 to 1-3/4 percent and anticipates that ongoing increases in the target range will be appropriate. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in the Plans for Reducing the Size of the Federal Reserve's Balance Sheet that were issued in May. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michelle W. Bowman; Lael Brainard; James Bullard; Lisa D. Cook; Patrick Harker; Philip N. Jefferson; Loretta J. Mester; and Christopher J. Waller. Voting against this action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate by 0.5 percentage point to 1-1/4 percent to 1-1/2 percent. Patrick Harker voted as an alternate member at this meeting.

• Platinum reversed from support level 920.00
• Likely to rise to resistance level 960.00

Platinum recently reversed up from the support level 920.00 (which is the upper border of the support zone which has been reversing the price from the middle of September, the lower boundary stands at 900.00).

The upward reversal from the support level 920.00 stopped the previous minor retracement 2 from the start of June.

Given the oversold daily Stochastic, Platinum can be expected to rise further toward the next round resistance level 960.00.

• AUDUSD reversed from support level 0.6850
• Likely to rise to resistance level 0.7000

AUDUSD currency pair recently reversed up from the key support level 0.6850 (which stopped the earlier sharp downward impulse wave 1 in the middle of May).

The upward reversal from the support level 0.6850 is likely to create the daily Japanese candlesticks reversal pattern Bullish Engulfing – a strong buy signal for this currency pair.

Given the oversold daily Stochastic, AUDUSD can be expected to rise further toward the next round resistance level 0.7000.

The Bank of Japan will conclude its latest meeting early on Friday. No policy shifts are on the cards, even though inflation has reached its elusive 2% target. This spells more pain for the yen, which has been slaughtered by rising yields abroad and a trade shock stemming from energy prices. On the bright side, the sharp downtrend seems to be entering its final phase. 

Pedal to the metal

The Bank of Japan is now the only major central bank in the world that is not even thinking about raising interest rates. That’s because there isn’t much inflation to fight. The yearly CPI rate recently crossed above the BoJ’s 2% target but most of that boils down to soaring energy and food costs.

Supply shocks don’t have a lasting impact on inflation. What the BoJ wants to see is organic price pressures generated domestically, with people enjoying higher wages and spending more on goods and services.

Japan has been trapped in deflation for decades now and the BoJ is trying to use this supply shock to its advantage. If policymakers stay patient and manage to import enough inflation from abroad, that could help break the deflationary mindset that’s been embedded in Japanese society and kickstart the economy.

But this process requires the yen to suffer. The BoJ continues to keep a ceiling on Japanese yields, keeping them pegged around 0%. With yields in the rest of the world going through the roof, interest rate differentials have widened, crushing the yen.

Nothing yet

A parade of BoJ officials made it very clear lately that no policy changes are on the menu this week. The fact that they felt it was necessary not even to allow market participants to speculate about any potential changes says everything. They won’t lift a finger.

Instead, the spotlight will be on any signals that a move is possible in the next few meetings. A shift seems inevitable later in the year, but it is unlikely that the BoJ will open that door for now. It would defeat the purpose of trying to shock Japanese consumers back into expecting inflation.

When the BoJ does change tune, the first step would be to either relax its yield curve control strategy by raising the ceiling on Japanese yields, or abandon it altogether. However, this might be a story for September or beyond.

Yen outlook

As for the yen, there’s probably some more pain left as the BoJ bides its time, but the sharp downtrend seems to be approaching its bottom.

The yen’s collapse has turned into a political issue in Japan, putting enormous pressure on the government to intervene in the FX market to stop the bleeding. Government officials have resisted so far, aware that FX intervention would contradict the BoJ’s efforts to revive inflation. But with inflation already running above 2% and rising, patience is running out.

BoJ Governor Kuroda probably has a few more months to attempt his inflation experiment. If foreign yields or energy prices keep rising in the meantime, the yen could surrender more ground. In this scenario, dollar/yen could pierce above the recent two-decade high of 135.50 and aim for the 140.0 psychological region.

Now on the flipside, any signs that the BoJ is ready to loosen yield curve control or raise interest rates would probably mark a trend reversal. In this case, dollar/yen could fall back below 131.0 and aim for the 126.0 zone.

Keep a close eye on inflation. If it breaches 3% or higher heading into September, it would be a solid signal that the BoJ is about to turn the ship around.