The Fed Hiked by 0.75% Again & Downplayed Recession Fears, but is it Underestimating them the Way it did With Inflation?

Another Outsized Move

The US Federal Reserve delivered a back-to-back 75 basis points interest rate hike, in what was the fourth upwards adjustment in a row. Rates now stand at 2.25%-2.5% ^[1], which is the highest level since December 2018, highlighting the bank's aggressive and front-loaded tightening path.

Unlike the previous meeting, this time the decision was unanimous, with Mr Powell talking of "broad support" for the move, when asked about a bigger full percentage hike during the subsequent press conference. ^[2]

He also said the current rates are in the range "of what we think is neutral", adding that the policy needs to get to "at least to a moderately restrictive level", which he sees at somewhere between 3% and 3.5% based on the June Staff Economic Projections (SEP).

Officials reiterated that "ongoing increases in the target range will be appropriate". They also repeated their commitment to "returning inflation to its 2 percent objective", noting once again that they are "highly attentive to inflation risks".

Wednesday's decision came in the aftermath of another inflation jump earlier in the month, as headline Consumer Price Index (CPI) accelerated 9.1% in June year-over-year, from 8.6% prior.

No Forward Guidance

Mr Powell had recently being criticized for offering too specific forward guidance, mainly back in May when he had essentially shut the door at a bolder 75 basis points increases, on which he rescinded with July's and yesterday's hikes.

This time around and as rates are now at neutral, Chair Powell refrained from offering specific guidance for the next meeting, pivoting to a "meeting by meeting basis". He did not rule out another unusually large increase, but said that the decision will "depend on the data" that comes out in the meantime.

He did say however that as the policy tightens further, it "likely will become appropriate to slow the pace of increases", given the lagging nature of the impact on inflation and the economy.

Markets now price in a more moderate 0.5% move in September, over a 75% one. At the time of writing, CME's FedWatch Tool assigns a 66% probability to that outcome, from a roughly 50-50 split before Wednesday's comments.

It is clear that the central bank does not want to put itself in the corner, as it has already delivered 225 basis points worth of hikes, while the next meeting is in September. This approach makes sense, since the upcoming decision is two months away and this is just a massive amount of time, during which we expect two jobs reports and four inflation reports – two CPIs and two PCEs.

Furthermore, the upcoming September meeting will include the updated Staff Economic Projections (SEP), which will provide more details into the bank's thinking, whereas official's will have the chance - if they feel the need - to offer more hints during their annual gathering at Jackson Hole, taking place on August 25-27.

Recession Fears Dismissed

Yesterday's policy statement had few changes compared to the previous one, but the central bank added the "Recent indicators of spending and production have softened" sentence right at the beginning of it. This replaced the more upbeat "Overall economic activity appears to have picked up after edging down in the first quarter" reference, of the June statement.

Chair Powell acknowledged that growth is slowing and that the path to bring inflation down and sustain a strong labor market "has clearly narrowed".

However, he does not think that the US economy is currently in a recession, attributing this belief to the many areas of the economy that are performing "too well", pointing out the strong labor market.

He elaborated that with this happening and with 2.7 million people hired in the first half of the year, "it does not make sense that the economy would be in recession".

A Policy Mistake?

The million dollar question is whether the bank will be able to avoid crushing the labor market and the economy, as it tries to tame inflation. Although we do believe that the US economy has the potential to withstand monetary tightening, there is a distinct risk that the Fed may go too far and thus provoke a recession.

Officials have so far dismissed such fears, but one has to wonder whether it is underestimating such prospects and may end up making a similar mistake with the one did with inflation. It had repeatedly called it "transitory", before being forced to change tack and make bringing it down its top priority.

The US economy contracted during the first quarter and even if it avoids another negative print in Q2 (first preliminary reading is out later today), which would technically constitute a recession, the prospects of an economic slowdown are clear.

Over the course of this year, we have seen many institution downgrading their GDP forecasts for the global and the US economy. The latest one came from the International Monetary Fund (IMF) earlier this week, which downgraded its US GDP projections to 2.3% in 2022 and a meager 1% in 2023, from 3.7% in the April report. ^[3]

Market Reaction

Yesterday's move was widely expected by markets and the policy statement was little changed, with the Fed sticking by its commitment to bring down Inflation, while playing down prospects of hard landing.

However, unlike previous times, Chair Powell did not offer any hints as to the bank's intentions for September, shifting to a "meeting by meeting" approach.

The US Dollar reacted negatively to this reference, whereas the SPX500 benefited and set new monthly highs.

The Fed's aggreesive rate-hike cycle has been the main source of strenght for the US Dollar this year and a key factor in the slump of the stock market. But rates are now at neutral and the Fed appoaches its end target, which could mean its hawksinness has peaked. If this is the case, then USD strength could moderate and the stock market may be able to form credible bottom and recover.