Swift monetary tightening will likely continue through the summer following the Federal Reserve’s first 50 basis point (bp) hike in the fed funds rate since 2000. The Fed also announced a plan for balance sheet runoff. Ongoing inflation risks prompted the May meeting’s notable policy moves: The Fed’s favored U.S. inflation measure exceeded 5% in the first quarter, and Fed officials continue to see risks to the upside. So it’s no surprise Fed policy appears squarely focused on taming inflation, and the officials excluded any mention of downside risks to growth from the May statement. We expect a rapid reversal of pandemic-era rate cuts through the summer Fed meetings, including another 50 bp hike in June, consistent with Fed Chair Jerome Powell’s comments in the press conference.
However, despite the large rate hike and clear resolve to continue to fight inflation, the details of May’s meeting and press conference were not as hawkish as many market participants had expected, and the bond market reacted accordingly. Powell downplayed the need for 75 bp rate hikes, and emphasized that the Fed will need to be “nimble” to react to the ongoing evolution of economic data. This was consistent with PIMCO’s expectation that the rapid pace of tightening this summer will be followed in the fall and winter by continued, but less aggressive, rate increases.
We agree that the Fed will have to navigate nimbly in the coming months as it tries to tame high inflation without breaking the U.S. economy. While the economy is starting from a position of strength, including stable household and business balance sheets, we see downside risks to growth amid a faster monetary tightening cycle, withdrawal of fiscal support, elevated geopolitical uncertainty, lockdowns in China, and depressed confidence levels, which will make the Fed’s desired soft landing difficult to achieve. The 1.4% contraction in real U.S. GDP in the first quarter was a reminder that reopening and rebalancing the economy will be a bumpy process. As growth slows, we expect the Fed will inject smaller moves and/or pauses into an otherwise rapid tightening cycle.
May meeting details: 50 bps, not 75
The Fed managed to deliver the largest rate hike since 2000 while at the same time surprising market participants somewhat on the dovish side. Powell suggested another 50 bp hike would be considered at the June and July meetings, and further tightening this year, but he pushed back on the 75 bp hikes market participants had begun to consider.
The Fed also unveiled its plan for running down the balance sheet, which was in line with details published in the March meeting minutes. The pace of the runoff will be nearly twice as fast as in the previous cycle (2017–2019), with a $60 billion monthly cap for reinvesting principal in U.S. Treasuries and a $35 billion cap for mortgage-backed securities (MBS). The caps will be phased in from June through September at 50% of the final pace (versus 12 months phasing in last cycle). In months where Treasury coupon maturities don’t reach the monthly cap, the Fed will fill that cap by allowing Treasury bills to mature. However, there was no mention of the fact that MBS paydowns are also not expected to reach the caps, consistent with the guidance that Fed officials likely won’t revisit this issue until the balance sheet runoff is “well under way.”
Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.
Allison Boxer is an economist and regular contributor to the PIMCO Blog.