The signs of an economic slowdown are there, but what will move the markets on the FOMC decision are signs of a slowdown in the pace of rate hikes.
The market may focus on the small difference between 75 basis points and 100 basis points, but what matters in the end is the final destination of the fares. Currently, the fed funds futures market peaks at 3.38% in December/February and then declines to 2.88% by November 2023.
What I will be looking for in the FOMC decision on Wednesday, July 27, 20022 are signs that the shape of this fed funds curve is about to change.
On the hawkish side, this could mean that rates will be held at higher levels for longer, bringing the November 2023 level back above 3%.
This can be difficult for the Fed to do as the credibility of officials beyond a few months is strained.
On the dovish side, the Fed could recognize signs that growth is stumbling. With that, it will put downward pressure on inflation and could ultimately validate the “transitional” narrative coming out of the pandemic, albeit certainly on a longer and stronger scale.
Don’t wait for the Fed to say anything explicit, like seeing a spike in inflation. The Fed is sorely failing in its mandate on price stability with inflation at 9.1% y/y and the failure to forecast rising prices or act quickly enough has left it politically hurt.
The risk is that they are now tightening too much too fast and unnecessarily punishing the economy with a severe recession when prices were already falling.
Big evidence of that came Monday from Wal-Mart, which lowered business forecasts and said spending was shifting towards food from goods.
“This affects customers’ ability to spend in general merchandise categories and requiring more markdowns to browse inventory, especially clothing,” the company said in the statement.
This is not a unique situation. Companies in many categories of consumer goods have too much inventory and will lower their prices. Food prices in the United States have also stabilized and gasoline prices are down more than 10% in the past 30 days.
I could convincingly say that inflation has peaked here and will decline through the end of the year and into 2023.
What is more difficult to predict is where it will stabilize. Will it be 2% or 4%?
The Fed will grapple with this issue, but a big input will be demand. On Thursday, the Q2 GDP report is due and is expected at +0.5%, narrowly avoiding a second consecutive quarter of negative GDP and a technical recession.
Fed policymakers will be quick to dismiss this due to inventory effects and other one-offs, but they are mindful of the potential for a full-blown recession starting later this year.
What is important to note is that so far Fed policymakers have rejected this. But given some recent economic data, that becomes harder to do. There are signs of a very rapid slowdown in housing, which is one of the areas most sensitive to Fed rate hikes. This kind of pain will also appear elsewhere in time.
Comments from the two main Fed hawks – Waller and Bullard – indicate that their models show rates peaking at 3.75%, but that is in a scenario of continued positive growth.
“I personally think some of the fears of a recession are a little overblown,” Waller said July 7.
“We have a good chance of making a soft landing,” Bullard said the same day.
What happens when Fed officials see evidence of a rapid slowdown in growth?
We may be about to find out. In all likelihood, this means they are moving to a slower pace of rate hikes or a more wait-and-see mode. This could mean a decline of up to 25 basis points in September versus the 50 basis points that are more than expected at the moment. Or it could mean another 75 basis points in September and then a full break.
“I expect the upside to continue past July at a pace that depends on incoming data,” Waller said in early July.
This kind of change from Powell and the Fed, or even a hint of openness towards it, may be all the markets need to sell the US dollar and buy risky assets.