US Federal Reserve policy meeting
The US Federal Reserve (‘the Fed’) hiked its target range for the federal funds rate by 75 basis points to a target range of 1.50-1.75 per cent, the biggest increase since 1994, to combat 40½-year high inflation.
Fed Chair Jerome Powell said, “Clearly today’s 75 basis point increase is an unsually large one and I do not expect moves of this size to be common,” but added “From the perspective of today, either a 50 basis point or a 75 basis point increase seems most likely at our next meeting [on July 26-27, 2022]”.
According to the “dot plot” of individual Fed members’ projections, the benchmark interest rate is expected to end the 2022 calendar year at 3.4 per cent, an upward revision of 1.5 percentage points from the March 2022 estimate. US economic growth, as measured by GDP, is now forecast to expand by 1.7 per cent in 2022.
The Fed reiterated that it had begun shrinking its balance sheet of US Treasuries and mortgage-backed securities by US$47.5 billion per month from June 1, 2022 and will step this up to US$95 billion in September.
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Commonwealth Bank (CBA) Group economists have pencilled in a 75 basis point increase in the federal funds rate in July, followed by 25 basis point increases in September, November and December. By the end of the 2022, we expect the federal funds rate target range to be 3.00‑3.25 per cent.
What does it all mean?
- The US Federal Reserve (‘the Fed’), the world’s most powerful central bank, voted to increase the federal funds rate by three-quarters of a percentage point or 75 basis points to a target range of 1.50-1.75 per cent. It was the biggest interest rate hike since 1994 in an attempt to dampen inflationary pressures.
- Just one member of the central bank’s policy-setting Federal Open Market Committee (FOMC), Kansas City Federal Reserve President Esther George, preferred a smaller 50 basis point increase.
- The Fed’s updated economic forecasts (detailed below) suggest that the pace of policy tightening will remain intense in the second half of 2022. US Fed Chair Jerome Powell said, “Clearly today’s 75 basis point increase is an unusually large one and I do not expect moves of this size to be common,” but added “From the perspective of today, either a 50 basis point or a 75 basis point increase seems most likely at our next meeting [on July 26-27, 2022].”
- The US central bank is acting more aggressively to lift interest rates and ‘normalise’ monetary policy settings in response to pandemic and Ukraine war induced supply-demand imbalances. But there is only so much the US central bank can do policy-wise due to the uncertain geo-political backdrop, ongoing Covid restrictions in China and the lack of available worker supply, which is pushing up wages and prices. Given this environment, inflation is likely to be slow and ‘sticky’ on its descent, meaning that the Fed will have to ‘front-load’ rate increases to dampen demand.
- US Fed Chair Jerome Powell acknowledged, “it will take some time” to get inflation back down, but Powell is confident that “we will do that.” In its policy statement, the FOMC said, “We at the Fed understand the hardship that high inflation is causing. We’re strongly committed to bringing inflation back down, and we’re moving expeditiously to do so.”
- Most economists had thought that US consumer prices had peaked prior to the release of last Friday’s “hot” inflation report. But the US Consumer Price index (CPI) surged by 8.6 per cent over the year to May 2022 – the biggest annual gain since December 1981. Excluding food and energy (core CPI), prices are up 6 per cent on the year, below the 6.5 per cent lift in March, which was the strongest annual pace since August 1982. And the core personal consumption expenditures (PCE) deflator, which the Fed uses for its 2 per cent inflation target was 4.9 per cent higher over the year to April, down from February’s 5.3 per cent reading, which was the highest since April 1983.
- Supply-chain disruptions, soaring commodity prices – due in part to the Ukraine war – and strong consumer demand are fanning US inflation. US consumer prices accelerated in May as gasoline prices hit a record high, up 4.1 per cent in the month. Natural gas prices jumped 8 per cent, the most since October 2005, and electricity prices increased 1.3 per cent. Rents increased by 0.6 per cent in May – the most since August 1990. And food prices jumped 1.2 per cent as dairy prices posted their biggest gain since July 2007. Elsewhere, the cost of airfares surged 12.6 per cent with new car prices up 1.0 per cent.
- Over the year to May 2022, the cost of gasoline (up 48.7 per cent), airfares (up 37.8 per cent), hotel rooms (up 19.3 per cent), energy (up 19.1 per cent), used vehicles (up 16.1 per cent) and food at home (up 11.9 per cent) have all soared. The broadening and relentless lift in price pressures are forcing Americans to change their spending habits.
- Also supporting the US inflationary pulse has been an extraordinarily tight labour market. Job growth momentum has slowed in recent months with the unemployment rate holding near 50-year lows of 3.6 per cent between March and May, 2022. But that is little consolation for American employers struggling to attract and retain workers. In fact, there were 11.4 million job vacancies in April, down from March’s record high of 11.9 million available positions. And there were 1.9 job openings for every unemployed person, suggesting that wage pressures will continue to build as firms compete for workers. US wage growth has averaged 6.1 per cent in recent months, showing no signs of abating, with aggregate wages and salaries in the April personal income report up 11.7 per cent on a year ago.
- The Employment Cost Index (ECI) rose by 1.4 per cent in March quarter of 2022 to be up by a record 4.5 per cent on a year ago. The higher wage costs are feeding into higher prices as companies charge their customers more to offset rising labour and materials costs. Producer prices rose by 10.8 per cent over the year to May. In response, a net 72 per cent of small businesses surveyed by the National Federation of Independent Business (NFIB) raised prices last month, matching the highest ever share.
- The US “inflation shock” is weighing on consumer confidence. The University of Michigan’s consumer sentiment index plunged to a record low of 50.2 points in June, even lower the previous trough of 51.7 points last seen in the 1980s recession. Household worries about the potential for ‘stagflation’ and/or inflation becoming entrenched was reflected in the survey. The measure of 1-year inflation expectations lifted from 5.3 per cent to 5.4 per cent and 5-10 year inflation expectations jumped from 3 per cent to 3.3 per cent.
- Retail spending has increased by a staggering US$266 billion since April 2020, supported by trillions of dollars in Covid-19 relief payments, a strong labour market and excess savings. Estimates from the US Federal Reserve show that the collective net worth of Americans has increased by US$32.6 trillion over the two years to March 2022, with the bottom 50 per cent of households seeing their wealth lift by around US$3.7 trillion, almost doubling.
- But overall household net worth declined by US$544 billion in the March quarter, 2022 – the first decline during the pandemic – as the value of shareholdings fell. And key drivers of savings like the child tax credit have ended, forcing Americans to dip into their savings as prices surge. In April, the saving rate dropped to 4.4 per cent, its lowest level since 2008.
- With cost of living pressures and negative real earnings causing US households increasing pain, the Fed is hoping to tame inflation and engineer a ‘soft landing’ for the US economy by dampening excess demand in the economy. Policymakers hope that by increasing the cost of borrowing for mortgages, credit cards and auto loans (that is, tightening credit) that the economy will slow, tempering inflation, after the pandemic-induced consumer spending binge.
- US Federal Reserve Chair Powell is confident that monetary policy tightening won’t cause an economic downturn as it attempts to head off both supply-push and demand-pull inflationary pressures. And Fed officials are hoping that inflationary pressures will ease as supply chain dislocations abate. But complicating the task is the extremely tight labour market and persistent wages pressures.
- While the Fed has a dual mandate focusing on both the labour market (“full employment”) and keeping inflation anchored at its 2 per cent target, it appears that its policy objectives are becoming increasingly focused on taming price pressures by aggressively hiking interest rates. In fact, today’s Fed statement dropped the expectation of a strong labour market, instead emphasising that the Committee is “strongly committed” to returning inflation to target.
- Historically it has been difficult for the Fed to engineer a soft economic landing after launching a monetary policy tightening cycle. Economists and investors have already begun pricing in the likelihood of weak US economic growth in the second half of 2022, with the potential for a 2023 recession increasing.
Policy changes, forward guidance and economic forecasts
- As widely expected, the US Federal Reserve this morning increased its target range for the federal funds rate by 75 basis points to 1.50-1.75 per cent, the biggest rate hike since 1994, following a 50 basis point rate hike on May 4.
- Interest rate forward guidance: In terms of forward guidance on interest rates, US Federal Reserve Chair Powell said that another 50 basis point or 75 basis point move was likely at the July 26-27 FOMC meeting. He added, “I do not expect moves of this size to be common.” But he added that decisions will be made “meeting by meeting,” the Fed will “continue to communicate our intentions as clearly as we can,” and “If we don’t see progress … that could cause us to react.”
- Interest rate forecasts: In the latest “dot plot” forecasts by individual FOMC members, the Fed’s benchmark interest rate is expected to end 2022 at 3.4 per cent, an upward revision of 1.5 percentage points from the previous March 2022 estimate. The mid-point of the target range of individual member’s expectations is expected to hit 3.8 per cent in 2023, up 1.0 percentage point from the previous estimate in March.
- Economic growth forecasts: Fed officials cut their economic growth forecasts with economic growth (GDP) expected to expand by 1.7 per cent in 2022, down from the previous estimate of 2.8 per cent in March. GDP projections were also revised down for 2023 (-0.5 percentage points [pp] to +1.7 per cent), and 2024 (-0.1pp to +1.9 per cent).
- The median core inflation (personal consumption expenditure deflator) forecast for 2022 was revised up in 2022 (+0.2pp to 4.3 per cent) and 2023 (+0.1pp to 2.7 per cent), but was unchanged in 2024 at 2.3 per cent. So inflation is anticipated to ease in the coming months.
- The FOMC expects the unemployment rate to increase slightly from 3.6 per cent in May to 3.7 per cent by the end of 2022. And the jobless rate is tipped to edge higher to 3.9 per cent by the end of 2023 and 4.1 per cent by the end of 2024.
- Fed balance sheet (‘Quantitative Tightening, QT’): The Fed reiterated that it had begun shrinking its near US$9 trillion balance sheet of US Treasuries and mortgage-backed securities by $47.5 billion per month on June 1, 2022 and will step this up to US$95 billion in September 2022.
US financial markets reaction
- US sharemarkets posted solid broad-based gains overnight (Wednesday), halting a five-day decline. Shares were volatile immediately after the interest rate announcement, before turning higher after US Fed Chair Powell said in his press conference that either 50 basis points or 75 basis points were most likely at the next meeting in July, but that he did not expect hikes of 75 basis points to be common. The Dow Jones index closed up by 304 points or 1.0 per cent. The S&P 500 index rose by 1.5 per cent and the Nasdaq index climbed by 271 points or 2.5 per cent.
- The US treasuries curve steepened after Fed Chair Powell said that a move of 50 or 75 basis points is likely at the next July meeting, downplaying chances of a more forceful move. At the close of US trade on Wednesday, US treasuries rose (yields lower) with the US 10-year yield down by 19 points to near 3.29 per cent and the US 2-year yield fell by 22 points to near 3.22 per cent.
- The Bloomberg US dollar spot index eased after the Fed’s rate decision. But major currencies were mixed against the US dollar in European and US trade. The Euro eased from highs near US$1.0505 to lows near US$1.0360 and lifted to near US$1.0450 at the US close. The Aussie dollar rose from highs near US68.90 cents to highs near US70.25 cents and was near US70.00 cents at the US close. The Japanese yen lifted from near 134.90 yen per US dollar to JPY133.55 and was near its JPY133.72 at the US close.
- The Australian share market is expected to rebound on Thursday following a solid night on Wall Street. According to the latest SPI futures, the ASX 200 index is expected to open the day 24 points or 0.4 per cent higher this morning.
Commonwealth Bank (CBA) Group Forecasts
- Commonwealth Bank (CBA) Group economists have pencilled in a 75 basis point increase in the federal funds rate in July, followed by 25 basis point increases in September, November and December. By the end of the 2022, we expect the federal funds rate target range to be in a range of 3.00‑3.25 per cent. But the risk is the FOMC increases the Funds rate by 50 basis points in September. Our forecasts are close to both market pricing and the FOMC projections.
- We also expect the FOMC to increase the federal funds rate by 25 basis points in January 2023 and March 2023 to a peak of 3.50‑3.75 per cent. Reflecting increasing recession risks, we expect the FOMC to cut the federal funds rate by 125 basis points to a range of 2.25‑2.50 per cent starting in November 2023. By comparison, the market is pricing a more modest cut to the federal funds rate.
Implications for Aussie investors
- It’s been a turbulent first half of the year for Aussie investors. A more aggressive approach from global central banks to tame rampant inflation has seen markets re-price interest rate and inflation expectations. The rout in government bond markets has extended to Australia with the interest rate sensitive 3-year Australian government bond yield surging to a 10-year closing high of 3.69 per cent yesterday, jumping almost 60 basis points in two days, the largest move since June 1994. And the 10-year Australian government bond yield jumped 25 basis points yesterday to 4.2 per cent, the highest closing level since March 2014
- The Reserve Bank of Australia (RBA) has begun front-loading rate increases, raising its cash rate by a surprise 50 basis points last week for the first time in 22 years. Governor Philip Lowe said on TV this week that he’s prepared to do whatever it takes to rein in inflation. CBA Group economists expect the RBA to increase from current levels of 0.85 per cent to 2.1 per cent by the end of 2022.
- We expect that aggressive rate hikes by central banks will contribute to further volatility in global sharemarkets over the coming months. In the current environment of elevated inflation and rising interest rates, investors are likely to pay even closer attention to company valuations and earnings growth, with a likely contraction in price to earnings (PE) ratios. While share prices have already declined, earnings have further room to fall as economic growth slows.
- Rising interest rates historically have not necessarily resulted in falling Aussie shares, as evidenced by the RBA’s rate hike cycle between 2003 and 2007, where the All Ordinaries Index actually rose. That said, there have been 11 technical “bear markets” (a correction of 20 per cent or more from the most recent high) since 1970. If you exclude the short and sharp correction at the height of the pandemic from March 23, 2020 (down 38.8 per cent), Zurich research shows that “bear markets” have typically lasted around 13 months in duration with the ASX All Ordinaries index down by 35.8 per cent on average.
- The benchmark Aussie ASX 200 index is currently down 11.3 per cent in 2022 (to June 15, 2022), but much will depend on the profit growth outlook for companies and the success of the RBA getting inflation back into its 2-3 per cent target range. The year-to-date sell-off in shares has largely been valuation driven, and an easing of price pressures would reduce recession fears together with Chinese growth stimulus. Therefore, a potential bond rally and the current discount in valuations could yet support higher equity prices.
Originally published by CommSec