Fed tapping harder on the brakes
At its May meeting, the FOMC raised the target range of the fed funds rate by 50bp, to 0.75-1.00%, in line with our and consensus expectations. In addition, at the press conference Chair Powell strongly signalled further such super-sized rate moves, saying that the Committee expected 50bp rises to be considered at the 'next couple of meetings'. Given this signalling, we now expect the Fed to raise rates 50bp at both June and July meetings; previously, we expected the Fed to shift back to a 25bp hiking pace in July.
Moving 'expeditiously' back to neutral
Repeatedly during the press conference, Powell stressed the need for the fed funds rate to move 'expeditiously' to neutral levels, which as of the March projections the Committee pegs at 2.4%. We keep our expectation for the terminal rate at 2.50-2.75% at this stage, given the many significant facing the economy, but expect this level to be reached in December rather than our previous January expectation. This expectation assumes that inflation begins to decline over the coming months, albeit remaining at elevated levels. If this does not happen, the Fed is likely to need to hike rates beyond 2.50-2.75%.
In the Q&A with reporters, Powell gave a number of additional clues on the Committee's thinking. First, on the prospect of 75bp hikes, Powell stated that the Committee was not 'actively considering' such a move, and in separate remarks he also said that the Fed wanted to 'avoid adding uncertainty at an already uncertain time' (reading between the lines, such a move would indeed add uncertainty to the policy outlook). Second, on where the neutral rate is, Powell emphasised the role of financial conditions in guiding this, stating that conditions 'tightening appropriately' would signal to the Fed that it is at or moving beyond neutral levels. This is consistent with our view that a further tightening in conditions will likely be necessary for the Fed to feel it is doing enough to tighten policy. Third, when questioned on whether the Fed would need to see a demand contraction that sufficiently offsets the supply shocks facing the economy - including those that are external, such as Russia-Ukraine and China lockdowns - Powell said that there was plenty the Fed could do to deal with domestic supply-demand imbalances (such as bringing down the exceptionally high ratio of job vacancies to unemployed people), but that signs of inflation expectations becoming unanchored (not yet evident) would signal that the Fed needs to go even further than this. Put another way, we interpret this to mean that a recession could well be necessary to bring inflation down if expectations drift materially higher.
Alongside raising rates, the Committee also announced that it will allow maturing bonds to come off the balance sheet (aka 'quantitative tightening', or QT) from 1 June, with initial amounts capped at $47.5bn per month ($30bn Treasury, $17.5bn MBS), doubling to a monthly pace of $95bn from September. This is a little later than we thought (we expected runoff to already start in May, ramping up to the maximum in August), but is otherwise broadly in line with our expectation. When asked again about the monetary policy impact of QT, Powell clarified that it was estimated to be the equivalent of one 25bp hike per year, although there are wide uncertainty bands around this estimate.