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FOMC minutes indicate Fed may go for a real positive rate

FOMC minutes indicate Fed may go for a real positive rate

calendar 24/11/2022 - 21:45 UTC

On Wednesday, all focus was also on FOMC minutes for the 2nd November meeting, in which Fed hiked +0.75% as highly expected with a hint of a slower pace of hikes (not pause) in the coming months. Wall Street Futures, Gold surged, while USD slumped after FOMC minutes showed: “A substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate”.

Highlights of FOMC minutes:

Developments in Financial Markets and Open Market Operations

·         Over the period, financial conditions had tightened amid elevated volatility across financial markets. The market-implied path of the policy rate rose, with the median federal funds rate values in the September Summary of Economic Projections and other Federal Reserve communications being viewed by market participants as indicating a commitment to sustaining a restrictive monetary policy stance

·         With data received over the period also indicating higher-than-expected core inflation, market participants placed high odds on a 75 basis point increase in the target range at the current meeting

·         Nonetheless, contacts were increasingly focused on the question of when the Committee might slow the pace of future increases in light of the substantial tightening of financial conditions that had occurred over the year

·         Most respondents to the Open Market Desk's surveys viewed a 50 basis point increase in the target range for the federal funds rate at the December meeting as the most likely outcome

·         The manager pro tem turned next to a discussion of volatility in global financial markets. In September, an expansionary budget announced by the U.K. government resulted in an extraordinary rise in yields on gilts (long-dated U.K. government securities) and reduced gilt market liquidity. Reflecting its financial stability objective, the Bank of England initiated a temporary gilt purchase program designed to address disorderly market conditions. These purchases and subsequent cancellation of some announced expansionary U.K. budgetary measures resulted in a retracement of much of the earlier increase in gilt yields

·         Elevated volatility in international financial markets contributed to volatility in U.S. core fixed-income markets

·         The foreign exchange value of the dollar appreciated further over the period. Market participants perceived several Asian economies as engaging in foreign exchange market interventions in response to the rapid depreciation of local currencies

·         In the case of advanced economies, whose monetary policy tightening was well underway, market participants focused on communications perceived as signaling a potentially slower pace of policy rate increases in the period ahead

Staff Review of the Economic Situation

·         The information available at the time of the November 1–2 meeting suggested that U.S. real gross domestic product (GDP) had increased at a moderate pace in the third quarter after having declined over the first half of the year. Labor market conditions remained quite tight, and consumer price inflation—as measured by the 12‑month percentage change in the price index for personal consumption expenditures (PCE)—remained elevated

·         The three-month change in the ECI in September was noticeably lower than the average pace seen over the first half of the year

·         Consumer price inflation remained elevated. Total PCE price inflation was 6.2 percent over the 12 months ending in September, and core PCE inflation, which excludes changes in consumer energy prices and many consumer food prices, was 5.1 percent over the same period. The trimmed mean measure of 12‑month PCE price inflation constructed by the Federal Reserve Bank of Dallas was 4.7 percent in September. The staff's common inflation expectations index, which combines information from many indicators of inflation expectations and inflation compensation, was little changed in the third quarter but remained above pre-pandemic levels

·         Data pointed to weakening foreign economic activity in recent months, weighed down by the economic fallout of Russia's war against Ukraine, headwinds in China, and tighter financial conditions. In many advanced foreign economies, high inflation and disruptions to energy supply contributed to a decline in real disposable incomes and depressed consumer and business confidence

Staff Review of the Financial Situation

·         The rise in borrowing costs appeared to have slowed the volume of financing in many credit markets. Credit quality remained sound overall, al­though there are some signs of deterioration for lower-rated borrowers

·         The expected path of the federal funds rate implied by a straight read of financial market quotes rose notably over the intermeeting period, largely reflecting more-restrictive-than-expected monetary policy communications and data releases that pointed to inflation moving down more slowly than previously expected

·         Broad equity price indexes fell significantly early in the intermeeting period, with inflation news and monetary policy expectations likely being the main drivers of stock price movements. However, equity prices later rebounded and ended the period essentially unchanged on net

·         Household borrowing was moderate, and mortgage performance remained strong. Nonfinancial businesses' leverage continued to decline, and interest coverage ratios continued to increase; however, further increases in borrowing costs could pose risks to some borrowers' ability to service their debts

Short-term funding markets continued to have structural vulnerabilities

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Staff Economic Outlook

·         The projection for U.S. economic activity prepared by the staff for the November FOMC meeting was weaker than the September forecast. Broad financial conditions were expected to be considerably more restrictive over the projection period than in September, reflecting both recent market moves and upward revisions to the staff's assumptions regarding the future course of monetary policy based on recent Federal Reserve communications. As a result, output was expected to move below the staff's estimate of potential early in 2024 and to remain below potential in 2025. Likewise, the unemployment rate was expected to be above the staff's estimate of its natural rate in 2024 and 2025

·         On a 12‑month change basis, total PCE price inflation was expected to be 5.3 percent in 2022, and core inflation was expected to be 4.6 percent. The staff raised their projection for core PCE price inflation in coming quarters, reflecting their assessment that the factors that had boosted inflation since the middle of last year—most notably, strong wage growth and the effect of supply constraints on prices—would persist for longer than previously thought

·         With the effects of supply-demand imbalances in goods markets expected to unwind and labor and product markets expected to become less tight, the staff continued to project that inflation would decline markedly over the next two years; in 2025, both total and core PCE price inflation was expected to be 2 percent

·         With inflation remaining stubbornly high, the staff continued to view the risks to the inflation projection as skewed to the upside

·         For real activity, sluggish growth in real private domestic spending, a deteriorating global outlook, and tightening financial conditions were all seen as salient downside risks to the projection for real activity; in addition, the possibility that a persistent reduction in inflation could require a greater-than-assumed amount of tightening in financial conditions was seen as another downside risk

·         The staff, therefore, continued to judge that the risks to the baseline projection for real activity were skewed to the downside and viewed the possibility that the economy would enter a recession sometime over the next year as almost as likely as the baseline

Participants' Views on Current Conditions and the Economic Outlook

·         In their discussion of current economic conditions, participants noted that recent indicators pointed to modest growth of spending and production. Nonetheless, job gains had been robust in recent months, and the unemployment rate had remained low. Inflation remained elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures. Participants recognized that Russia's war against Ukraine was causing tremendous human and economic hardship. The war and related events were creating additional upward pressure on inflation and weighing on global economic activity. Against this background, participants continued to be highly attentive to inflation risks

·         With regard to current economic activity and the near-term outlook, participants observed that al­though real GDP rebounded in the third quarter, recent data suggested that economic activity in the near term appeared likely to expand at a pace below its trend growth rate. Participants noted a softening in consumer and business spending growth, and some participants remarked that there had been a notable slowing in interest rate-sensitive sectors, particularly housing, in response to the tightening of financial conditions associated with the Committee's policy actions

·         With inflation remaining far too high and showing few signs of moderating, participants observed that a period of below-trend real GDP growth would be helpful in bringing aggregate supply and aggregate demand into better balance, reducing inflationary pressures, and setting the stage for the sustained achievement of the Committee's objectives of maximum employment and price stability

·         In their discussion of the household sector, participants noted that growth in consumer spending had softened recently. Several participants remarked that there had been a reduction in discretionary expenditures, especially among lower- and middle-income households, whose purchases were shifting toward lower-cost options. Participants observed that, in aggregate, household-sector balance sheets were still strong and that this factor would continue to support consumer spending. A few participants noted that some households had been running down the additional savings they had accumulated during the pandemic and that there were reports of a rise in the number of households experiencing financial strains. Participants commented that higher mortgage interest rates had notably restrained housing activity

·         With regard to the business sector, participants noted that growth in investment spending was modest. Several participants observed that business investment was being weighed down by tighter financial conditions, although a few participants reported that some business contacts indicated that their investment spending had been resilient. Some participants mentioned reports received from business contacts of easing supply bottlenecks, reflected in declines in shipping costs and delivery times, although the reported extent of these improvements varied across contacts

·         A few participants remarked that, in instances in which supply constraints had eased, their business contacts found it easier to plan production or had diminished needs to maintain precautionary inventories. A couple of participants noted that drought conditions in the Midwest were making some waterways, notably the Mississippi River System, less navigable. These conditions were creating new supply constraints and putting upward pressures on transportation costs and prices for farm products

·         Participants observed that, with inflation elevated globally, many central banks were tightening monetary policy simultaneously, contributing to an overall tightening of global financial conditions. Participants further noted that the overall tightening of global financial conditions, along with energy prices and other headwinds, was contributing to a slowdown in the growth rate of global real GDP. Participants remarked that the foreign economic slowdown, in combination with a strong U.S. dollar, was likely to weigh on the U.S. export sector, and several participants commented that there could be wider spillovers to the U.S. economy

·         Participants observed that the labor market had remained very tight, with the unemployment rate near a historically low level, the number of job vacancies very high, a low pace of layoffs, robust employment gains, and elevated nominal wage growth

·         Some participants remarked that employers in certain sectors, such as health care, leisure, hospitality, or construction, faced particularly acute labor shortages and that these shortages were contributing to especially strong wage pressures in those sectors

·         Participants commented on the labor market has remained strong to date, even alongside the slowing in economic activity. A number of participants remarked that some businesses were keen to retain workers after their recent experiences of labor shortages and hiring challenges. These participants noted that this consideration had limited layoffs even as the broader economy had softened or that this behavior could limit layoffs if aggregate economic activity were to soften further

·         Nevertheless, many participants noted tentative signs that the labor market might be moving slowly toward a better balance of supply and demand; these signs included a lower rate of job turnover and a moderation in nominal wage growth. Participants anticipated that imbalances in the labor market would gradually diminish and that the unemployment rate would likely rise somewhat from its current very low level, while vacancies would likely fall

·         Participants agreed that inflation was unacceptably high and was well above the Committee's longer-run goal of 2 percent. Some participants noted that the burden of high inflation was falling disproportionally on low-income households, for whom necessities like food, energy, and shelter make up a larger share of expenditures. Many participants observed that price pressures had increased in the services sector and that, historically, price pressures in this sector had been more persistent than those in the goods sector. Some participants noted that the recent high pace of nominal wage growth, taken together with the recent low pace of productivity growth, would, if sustained, be inconsistent with the achievement of the 2 percent inflation objective.

·         Several participants, however, commented on signs of a moderation in nominal wage growth. Participants agreed that near-term inflation pressures were high, but some noted that lower commodity prices or the expected reduced pressure on goods prices due to an easing of supply constraints should contribute to lower inflation in the medium term.

·         Several participants remarked that rent increases on new leases had been slowing in recent months, but participants also noted that it would take some time for this development to show up in PCE inflation. Several participants summarized reports provided by business contacts about their firms' ability to pass on higher input costs to their customers. These reports suggested that some firms continued to have solid pricing power, while in other cases cost pass-through had become more difficult

·         Participants remarked that, overall, measures of medium- and longer-term inflation expectations obtained from surveys of households and businesses as well as from financial markets quotes appeared to have remained well anchored. A couple of participants observed that longer-term inflation expectations were stable even as measures of near-term inflation expectations responded to realized inflation in line with historical patterns

·         Participants noted that longer-term inflation expectations were an important influence on inflation's behavior and stressed that the Committee's ongoing monetary policy tightening would be essential for ensuring that these expectations remained well anchored

·         Several participants expressed the concern that the longer inflation remained well above the 2 percent goal, the greater the risk that longer-term inflation expectations could become unanchored. Such a development, if it materialized, would make it much more costly to bring inflation down and to achieve the Committee's statutory objectives of maximum employment and price stability

·         A couple of participants discussed the high dispersion of longer-term inflation expectations across respondents in various surveys: These participants noted that the higher dispersion may signal increased uncertainty about the inflation outlook and was a reason not to be complacent about longer-term inflation expectations remaining well anchored

·         Participants discussed the length of the lags in the response of the economy to monetary policy actions, taking into account historical experience and the various estimates of timing relationships provided in economic research, as well as the high degree of uncertainty involved in applying the evidence on lags to the current situation. They noted that monetary policy tightening typically produced rapid effects on financial conditions but that the full effects of changes in financial conditions on aggregate spending and the labor market, and then on inflation, likely took longer to materialize.

·         With regard to current circumstances, many participants remarked that, even though the tightening of monetary policy had clearly influenced financial conditions and had had notable effects in some interest rate-sensitive sectors, the timing of the effects on overall economic activity, the labor market, and inflation was still quite uncertain, with the full extent of the effects yet to be realized.

·         Several participants observed that, because of the difficulties in isolating the effects of monetary policy, changes in economic structure, or increasing transparency over time regarding monetary policy decisions, the historical record did not provide definitive evidence on the length of these lags. In addition, some participants noted that the post-pandemic dynamics of the economy may differ from those prevailing prior to the pandemic

·         Participants generally noted that the uncertainty associated with their economic outlooks was high and that the risks to the inflation outlook remained tilted to the upside. Participants observed that recent inflation had been higher and more persistent than anticipated. Some participants noted the risk that energy prices could rise sharply again amid geopolitical tensions. A few participants commented that the ongoing tightness in the labor market could lead to an emergence of a wage-price spiral, even though one had not yet developed

·         A number of participants judged that the risks regarding the outlook for economic activity were weighted to the downside, with various global headwinds being prominently cited. These global headwinds included a slowdown in economic activity occurring in China and the ongoing international economic implications of Russia's war against Ukraine

·         Participants observed that, because of high inflation pressures prevailing globally, monetary policy tightening was under way in many other economies—a development likely to affect foreign economic activity and carrying the potential for spillovers to the U.S. economy

·         In their discussion of issues related to financial stability, participants noted the importance of orderly functioning of the market for U.S. Treasury securities for the transmission of monetary policy, for meeting the financing needs of the federal government, and for the operation of the global financial system. Participants observed that, despite elevated interest rate volatility and indications of strained liquidity conditions, the functioning of the Treasury securities market had been orderly.

·         Noting that the value of resilience of the market for Treasury securities was underlined by recent gilt market disruptions in the United Kingdom, a number of participants discussed a range of issues that could be considered by the appropriate authorities regarding market resilience, including potential interactions of capital and liquidity regulations with market activity, oversight of key market participants, clearing and settlement practices, and the role and structure of the Federal Reserve's standing facilities.

·         A few participants noted the importance of being prepared to address disruptions in U.S. core market functioning in ways that would not affect the stance of monetary policy, especially during episodes of monetary policy tightening. Several participants noted the risks posed by nonbank financial institutions amid the rapid global tightening of monetary policy and the potential for hidden leverage in these institutions to amplify shocks.

·         In their consideration of appropriate monetary policy actions at this meeting, participants concurred that inflation remained well above the Committee's longer-run goal of 2 percent, and the recent data on inflation provided very few signs that inflation pressures were abating. The economic expansion had slowed significantly from last year's rapid pace, and recent indicators pointed to modest growth in spending and production in the current quarter

·         Despite the slowdown in growth, the labor market remained extremely tight, and nominal wage growth remained elevated. Against this backdrop, all participants agreed that it was appropriate to raise the target range for the federal funds rate by 75 basis points at this meeting and to continue the process of reducing the Federal Reserve's securities holdings, as described in the Plans for Reducing the Size of the Federal Reserve's Balance Sheet that the Committee issued in May

·         Participants observed that the policy rate hike at this meeting was another step toward making the Committee's monetary policy stance sufficiently restrictive to help ease supply and demand imbalances and to return inflation to 2 percent over time

·         In their consideration of appropriate monetary policy actions at this meeting, participants concurred that inflation remained well above the Committee's longer-run goal of 2 percent, and the recent data on inflation provided very few signs that inflation pressures were abating.

·         In their discussion of the effects of monetary policy actions and communications to date, participants concurred that the Committee had taken forceful steps to moderate aggregate demand in order to bring it into better alignment with aggregate supply. Financial conditions had tightened significantly in response to the Committee's policy actions, and their effects were clearly evident in the most interest rate-sensitive sectors of the economy, including residential investment and some components of business investment

·         Several participants commented that monetary policy actions and communications had helped keep longer-term inflation expectations well anchored—a situation that would help facilitate the return of inflation to the Committee's longer-run goal of 2 percent

·         Nevertheless, with realized inflation well above that goal and the labor market still very tight, participants agreed that ongoing increases in the target range for the federal funds rate would be appropriate and would help keep longer-term inflation expectations well anchored. Participants noted that, with regard to both real economic activity and inflation, it would take time for the full effects of monetary restraint to be realized and that these lags complicated an assessment of the effects of monetary policy

·         In discussing potential policy actions at upcoming meetings, participants reaffirmed their strong commitment to returning inflation to the Committee's 2 percent objective, and they continued to anticipate that ongoing increases in the target range for the federal funds rate would be appropriate in order to attain a sufficiently restrictive stance of policy to bring inflation down over time

·         Many participants commented that there was significant uncertainty about the ultimate level of the federal funds rate needed to achieve the Committee's goals and that their assessment of that level would depend, in part, on incoming data. Even so, various participants noted that, with inflation showing little sign thus far of abating, and with supply and demand imbalances in the economy persisting, their assessment of the ultimate level of the federal funds rate that would be necessary to achieve the Committee's goals was somewhat higher than they had previously expected

·         Participants mentioned a number of considerations that would likely influence the pace of future increases in the target range for the federal funds rate. These considerations included the cumulative tightening of monetary policy to date, the lags between monetary policy actions and the behavior of economic activity and inflation, and economic and financial developments.

·         A number of participants observed that, as monetary policy approached a stance that was sufficiently restrictive to achieve the Committee's goals, it would become appropriate to slow the pace of increase in the target range for the federal funds rate. In addition, a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate

·         A slower pace in these circumstances would better allow the Committee to assess progress toward its goals of maximum employment and price stability. The uncertain lags and magnitudes associated with the effects of monetary policy actions on economic activity and inflation were among the reasons cited regarding why such an assessment was important.

·         A few participants commented that slowing the pace of increase could reduce the risk of instability in the financial system. A few other participants noted that, before slowing the pace of policy rate increases, it could be advantageous to wait until the stance of policy was more clearly in the restrictive territory and there were more concrete signs that inflation pressures were receding significantly

·         With monetary policy approaching a sufficiently restrictive stance, participants emphasized that the level to which the Committee ultimately raised the target range for the federal funds rate, and the evolution of the policy stance thereafter, had become more important considerations for achieving the Committee's goals than the pace of further increases in the target range. Participants agreed that communicating this distinction to the public was important in order to reinforce the Committee's strong commitment to returning inflation to the 2 percent objective

·         Participants discussed a number of risk-management considerations related to the conduct of monetary policy. In light of the continuing broad-based and unacceptably high level of inflation and upside risks to the inflation outlook, participants remarked that purposefully moving to a more restrictive policy stance was consistent with risk-management considerations.

·         Some participants observed that there had been an increase in the risk that the cumulative policy restraint would exceed what was required to bring inflation back to 2 percent. Several participants commented that continued rapid policy tightening increased the risk of instability or dislocations in the financial system. There was wide agreement that heightened uncertainty regarding the outlooks for both inflation and real activity underscored the importance of taking into account the cumulative tightening of monetary policy, the lags with which monetary policy affected economic activity and inflation, and economic and financial developments

Conclusions:

The market is now expecting Fed will hike +50 bps on 14th December to +4.50% and then another 50-100 bps by Mar’23 to 5.00-5.50% depending upon the actual core inflation trajectory. Fed is now preparing the market for a possible series of smaller hikes (50 bps) and pauses down the road after reaching around +5.50%. But Fed is also confused about levels of an appropriate terminal rate and may start the debate in the December meeting to take a firm decision with a fresh SEP. Fed may go from meeting-to-meeting to a QTR-to-QTR approach in 2023 after Q1 ( if required further hikes). Fed may keep the terminal rate around +5.50% for at least 2023 to bring down core PCE inflation back to +2.00% on a sustainable basis.

The U.S. housing market and also the overall economy are slowing down. The U.S. employment is still almost at Fed’s maximum level despite some cooling, while inflation (core CPI/PCE) is still substantially above the Fed’s price stability target of +2.00% without any meaningful sign of cooling. Moreover, UM 1Y inflation expectation continues to hover above +5.00%, almost double the average pre-COVID rate.

Fed needs 1Y inflation expectations around +2.75% consistently for its +2.00% price stability mandate. The primary objective of the rapid Fed tightening is to first bring 1Y inflation expectations back to pre-COVID or even 4% consistently so that the inflationary mindset will change for both consumers and producers and actual inflation comes down. But that’s not happening despite a series of jumbo hikes by the Fed as the real rate of interest is still negative, even considering core inflation; Fed is still much behind the inflation curve, especially after market expectations of a Fed pivot in the coming days.

Thus Fed is now jawboning the market for a real positive rate, at least wrt average core inflation (CPI/PCE) of +5.50%. Fed is now preparing the market for a slower rate of increase, but higher for longer. Fed will now focus on an appropriate terminal rate, restrictive enough (real positive) to bring down inflation towards the +2% target over the medium term. When the cost of borrowing turns real positive or there is an elevated cost of capital, overall economic activity/demand bounds to slow down, leading to lower inflation (as lower demand will try to catch up with the constrained supply capacity of the economy). Also, a real positive rate would encourage savings than spending, negative for inflation.

There is also a need for supply-side reform to lower inflation. But unless Russia-Ukraine/NATO war/proxy war, geopolitical tensions, and subsequent economic sanctions resolve, supply-side lacunas may continue to linger. Europe, being the net importer of food & fuel and being overly dependent on Russia, is the biggest victim of this Ukraine war.

As per Taylor’s rule, for the US:

Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%

Here for U.S. /Fed

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=5.5% (average of core PCE and CPI)

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