May meeting minutes reaffirm probability of 50bp hikes in June and July

*The FOMC’s May meeting minutes revealed there was unanimous support among FOMC participants for May’s 50bp rate hike, with most participants also backing 50bp rate hikes in the next couple of meetings (June and July) in an effort to “expeditiously move the stance of monetary policy toward a neutral posture”. Moreover, the minutes suggest that conditional on developments in economic data, lifting rates into restrictive territory may be warranted.

*If the Fed were to hike rates 50bp at each of its next two meetings, that would lift the Fed funds target range to 1.75-2.00%, still some way short of the 2.4% median estimate of the neutral rate published in the Fed’s March Summary of Economic Projections, so even if the Fed dispenses with 50bp policy rate moves, a sequence of 25bp hikes are likely.

*Importantly, the minutes are perhaps in the early stage of laying the groundwork for an eventual policy pivot. With the Fed acknowledging that risks to real activity are tilted to the downside, the minutes indicate many participants want to raise rates aggressively now to buy policy optionality down the line that “would leave the Committee well positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments”. Currently the Fed is primarily focused on reducing inflation. If this adversely affects the economy and is associated with a deterioration in labor market conditions, the Fed will move back from its aggressive anti-inflationary rate hikes.

*Should labor market conditions deteriorate materially (an unemployment rate approaching 5 – 5.5%), we would expect FOMC members in public comments to begin emphasizing a balanced approach to the Fed’s dual mandate, with such statements likely preceding either a pause on rate increases or potential easing.

*With respect to the Fed’s balance sheet unwind, the minutes provided scant details beyond those already outlined in the policy statement and the Plans for Reducing the Size of the Federal Reserve’s Balance Sheet. The minutes reflected unanimous support among FOMC participants to begin unwinding the balance sheet on June 1, although several participants stressed “the potential for unanticipated effects on financial market conditions” – highlighting the wide range of uncertainty around the effects of the Fed’s balance sheet unwind.

*Similar to the March minutes, a number of participants once again advocated for active sales of mortgage backed securities (MBS) once the balance sheet unwind was well underway to shift the composition of the Fed’s portfolio to one comprised primarily of Treasuries in the long term.

*Despite acknowledging that risks to real activity are tilted to the downside, participants remain optimistic on the strength of underlying economic momentum, pointing to robust household consumption in Q1, strong household balance sheets, and tight labor market conditions. Many participants expect labor market tightness and elevated nominal wage growth to persist “for some time”, with participants noting that current nominal wage growth is “above levels consistent with two percent inflation”.

*Participants largely judged that risks to the inflation outlook were tilted to the upside, reflecting Russia’s ongoing invasion of Ukraine, supply chain disruptions associated with lockdowns in China, and the risk that inflation expectations become unanchored. The minutes indicate that the Fed’s business contacts report they have largely maintained the flexibility to pass on rising wage and input prices. Given the strength of aggregate demand, elevated nominal wage growth, and robust household balance sheets, some participants noted stronger than expected household consumption could accentuate inflationary pressures.

*The Fed staff made further upward revisions to their inflation forecasts between the March and May meetings, lifting their PCE inflation forecast to 4.3% in 2022 from 4.1%, and raising their 2023 forecast from 2.3% to 2.5%. The forecast revision was driven by an anticipation of higher import prices and a dynamic we had pointed out earlier (OER, services prices, and inflation – January 18, 2022) - “wage increases that would put more upward pressure on services prices than previously assumed”. Importantly, in their assessment of inflation, the Fed’s staff moved away from discussing the general resolution of “supply demand imbalances”, and explicitly acknowledge that moderating inflation through 2024 will be accomplished not only through a resolution of supply chain bottlenecks, but also by slowing aggregate demand.

Mickey Levy, mickey.levy@berenberg-us.com

Mahmoud Abu Ghzalah, mahmoud.abughzalah@berenberg-us.com

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