The Fed Forces Itself to Play Catch Up

Jacob Hess

June 16, 2022

• FOMC
• Inflation

The Fed hiked 75 bps in June after a strong May CPI report forced the FOMC to reconsider the 50 bps hike that was previously agreed upon. The markets which have been sensing the need for stronger a policy reaction had already priced in the move. In the debate on how large rate hikes should be, a 75 bps hike seems to be a fitting fence to ride between the 50 bps and 100 bps camps.

In fact, the June decision describes the economic situation as a whole as Chair Powell attempts to craft a soft landing of the US economy while tightening at a fast enough pace to combat inflation. That pace is a moving target that seems to shift with every CPI/PCE inflation report. It’s likely that the May CPI report played some part in swaying FOMC members to a 75 bps decision when 50 bps was the preferred move before.

While the sizing decision was important, the changes in the June version of the Summary of Economic Projections overshadowed it. There were large shifts in the views on GDP and inflation for 2022. The estimate of 2022 full year GDP growth was downgraded from 2.8% in March to 1.7% in June while the estimate of 2022 PCE inflation was upgraded from 4.3% in March to 5.2% in June. The shift is in line with the FOMC’s thinking that tightening will have to happen at a quicker pace.

The truth is, if the Fed is to follow through with its desired tightening path, it will have to leave behind any hopes of a “gradual” return to normal. The chart points out how the Fed has forced itself to play catch up by increasing the forecasted 2022 Fed funds rate at a faster pace than it has increased the actual rate. This has led to a higher “implied average pace of rate hikes per meeting” in the last four meetings. The inability to maintain a narrative on pacing provides evidence to those calling for the Fed’s credibility to be questioned. But the past few months have been uncertain times, and it would have been hard for anyone to foresee a Russian invasion of Ukraine or an outbreak of COVID-19 in China.

Another interesting thing to note in the Fed projections is the mismatch between the Fed funds rate projection and the core PCE inflation projection revisions. As mentioned above, the FOMC issued a large upgrade in its forecasted 2022 Fed funds rate (up from 1.9% in March to 3.4% in June) which was largely expected as a response to managing inflation expectations that are expected to have risen in the past months. However, the Fed did not feel the need to upgrade its view on core PCE inflation for 2022 with just a 0.2 ppts increase over the March projection in June to 4.3%.

The core PCE price index is sometimes noted as the “Fed’s favorite inflation measure,” so one would think that it would guide policy the most. In the March projections, both the Fed funds rate and core PCE inflation projections rose at a similar pace, intimating that FOMC members were reacting to core inflation. However, that message is not reflected as strongly in the June projections. It seems that the spikes in food and energy inflation may appear to the FOMC as persistent so members may feel like they need to address it through rate hikes.

The July meeting is around the corner and hawkish tones remain the theme amongst markets, central banks, and investors. Given that the summer is going to be one of hot prices, 75 bps might be on the table again with 50 bps looking like a more dovish option. The Fed finds itself playing catch up and speed is the only way to return to a sense of normalcy.