Largest hike in almost 30 years
The FOMC delivered a 75bp rate hike at its June meeting, the largest hike since 1994, and raised the target range for the federal funds rate to 1.50% – 1.75%. The Fed appears strongly committed to tame inflation and stated that the Committee is highly attentive to inflation risks. Fed Chair Powell began the press conference by reiterating that the Fed has both the tools and resolve to deal with inflation.
The risk of inflation expectations becoming de-anchored is obviously concerning for policymakers. Past cycles suggest that we often see inflation expectations stabilise before the end of a tightening cycle. So far, there is little sign of a stabilisation as inflation forecasts continue to rise sharply. On that note, Powell highlighted that the June preliminary inflation expectations were “quite eye catching.” Recent data from University of Michigan showed that 1-year inflation expectations rose to 5.4% while 5-year expectations rose 30bp to 3.3% after remaining anchored at 3.0% for the past four months.
Figure 1. University of Michigan 1y inflation expectations rose to 5.4%
Source: University of Michigan . Median expected price change next 12 months, Surveys of Consumers.
At a last week’s Sohn Conference Stanley Druckenmiller pointed out that inflation has never come down from above 5% without Fed funds rising above CPI.
Albeit, the market read some elements of the FOMC meeting dovishly. Chair Powell de-emphasized the likelihood of a 100bp hike in July and said that he does “not expect moves of this size to be common” suggesting that 50bps hikes are the base case increment going forward. Powell also noted that the recent inflation expectations data and CPI data changed their view as he explained why FOMC deviated from the forward guidance communicated at the May meeting.
However, in our view, unless there is compelling evidence that inflation is coming down, front-loading rate hikes remains the playbook for the Fed. The trend core inflation may be slowing somewhat but remains unacceptably high. 75bp rate hike would be the most likely outcome at the July meeting too, in our view.
The longer-term question is whether the Fed can engineer a soft landing for the US. Chair Powell has made it clear that the FOMC is not aiming to induce a recession. Obviously, consumer spending is the key uncertainty for the outlook as inflation outpaces wage growth. While the consumer continues to lean on credit, the demand side appears increasingly vulnerable to downside risks. The May retail sales report came below expectations across all measures as consumers pulled back on discretionary goods as higher prices on food and energy take up a growing wallet share. Guidance from Walmart and Target were significantly weaker than expected and consumer staples stocks have sold off dramatically. The spread between inventory levels and sales growth appears to be getting worse and rightsizing inventory levels through discounting and promotions is likely to accelerate.
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