Another Jumbo Hike

The US Federal Reserve decided on Wednesday to proceed with another jumbo rate hike of 75 basis points ^[1]. This was the fourth straight move of this size and the sixth consecutive increase. Interest rates now stand at 3.75-4.00%, which is the highest since the start of 2008.

The central bank has delivered 375 basis points worth of rate hikes since the March lift-off, in its most aggressive cycle in at least three decades. The main driver for this action is restoring price stability, as inflation remains elevated.

Chair Powell once again alluded to this in his opening statement, stressing that "my colleagues and I are strongly committed to bringing inflation back down to our 2 percent goal" ^[2]

The most recent data showed that the bank's preferred gauge, the Core Personal Consumption Expenditures (PCE), rose to 5.1% year-over-year in September, from 4.9% prior.

Slowdown Prep

High inflation and the strong labor market, with Unemployment at fifty-year lows, have provided the Fed with the runway to pursue such aggressive strategy. However, the adverse effects on the labor market and the economy have a lagging nature and officials need to take that into account, while the US economy contracted during the first two quarter of the year, even though it grew by 2.6% in Q3 (according to preliminary data.

Chair Powell has been trying to prepare markets for a moderation in the pace increases over the past few months given those considerations, repeating yesterday that at some point "it will become appropriate to slow the pace of increases".

However, this was the first time those considerations were explicitly reflected in the policy statement. The Committee now "will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments", in determining the pace of future hikes.

Of course the statement still pointed to ongoing increases, adding that this will be done "in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time".

No Error, No Pause

Chair Powell acknowledged the economic downturn, noting that "the U.S. economy has slowed significantly from last year's rapid pace", but he definitely does not see an error with the aggressive tightening. He defended the Fed's actions, noting that "I am pleased that we have moved as fast as we have. I don't think we've overtightened".

Even though, he spoke of potentially smaller rate hikes, which could come "as soon as the next meeting or the one after that", he stressed that there is still a "need for ongoing rate increases and we have some ground left to cover here".

He ruled out any pause, emphatically stating that It is "very premature to be thinking about pausing", adding that "we have a ways to go". It is clear from such commentary, that the Fed is looking to raise rates by smaller increments at some point in the future, but it does not plan to stray away from its tightening path any time soon.

Other central banks have already taken a step back in order to avoid a recession and to assess the impact of their policies, such as the Reserve Bank of Australia. Officials there have delivered two straight 25 basis points hikes, after a series of beefier 0.5% adjustments.

How Far

With the amount of progress that has been made in a small period of time, Chair Powell now shifted focus away from speed, to how far to go in raising rates, which "really does become the important question" now.

Contrary to some of its counterparts, such as the European Central Bank, I tended to believe that Fed policymakers had a somewhat clear picture of the terminal rate, given their quarterly projections.

Based on the latest update from September, officials expected the median rate to go as high as 4.6% ^[3], but looks like this has already become outdated, given the recent incoming data on inflation and the labor market.

Chair Powell now believes that "we may ultimately move to higher levels than we thought at the time of the September meeting", admitting that that that they don't know what the terminal rate is. He said that policy makers "have a sense" of where that is, but "don't really know exactly where" the sufficiently restrictive level is.

Market Reaction

I have commented before on how banks have to balance out competing forces, as high inflation compels them to continue tightening, but prospects of economic slowdown make them think they may need to shift their aggressive stance.

The Fed has been absolutely clear that restoring price stability remains the top priority, but also introduced some dovish elements to its rhetoric, causing two-way action in markets. After the dovish policy statement the US Dollar dropped, while bond markets and Wall Street jumped. However, Chair Powell appeared rather hawkish in the press conference, leading to a reversal.

It is interesting that towards the end, he was asked what he thought of the positive reaction in bond and stock markets, which was a bit misleading, since this had already shifted. Chair Powell replied that they "are not targeting any one or two particular things", but made sure to repeat all the hawkish elements of his speech.

This is a big departure from the Fed Put that was mastered by the prolific Alan Greenspan, which sought to contain big stock market declines, via supportive comments or policies. The Fed had already seemed OK with this year's plunge in Wall Street, but this was the clearest manifestation. Maybe it is trying to hit two birds with one stone - bring inflation down and avoid a future stock market bubble.