Fed gets tough on inflation but may need to get tougher

The Federal Reserve raised interest rates by 75 bps this week in order to combat surging inflation. Jerome Powell was quite uncertain surrounding the future path of inflation, but the 8.6% y/y headline print from last Friday did get the Fed’s serious attention. In the statement the Fed removed the language that the committee expects inflation to return to its 2% objective with the more intense phrase, ‘The committee is strongly committed to returning inflation to its 2% objective’. Reflecting these concerns inflation forecasts were revised higher and growth expectations lower.

The dot plot

The dot plots have all been revised higher with the 2022 rates seen at 3.4%. The terminal rate for 2023 is now seen at 3.8% and the longer-run neutral rate has been revised marginally higher to 2.5% from 2.4%. If inflation remains high, or surprises further the Fed has stated that it is ‘prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals’.

Energy prices

One of the key inputs for inflation is high energy costs. Jerome Powell said that ‘ we have to be mindful of the potential effect on inflation expectations, but we cannot affect energy prices’. Energy prices don’t look like going down anytime soon. A combination of low investment, Russian/Ukraine risk, green energy pivot, and rising demand are all keeping oil prices supported with no immediate change expected.

The verdict

Jerome Powell’s comments initially calmed markets by saying that jumbo rate hikes were rare. However, Jerome Powell said that the worst mistake the Fed could make would be to fail to get inflation down. Jerome Powell is also not sure he can manage a ‘soft landing’ (the ability to raise interest rates without sending the US into a recession) as it will depend on factors outside of the fed’s control. The outcome of this meeting is that the future is highly uncertain. The Fed may need to keep hiking interest rates in the face of even higher inflation. The path of the USD remains uncertain too. On one hand, a lot of this has been priced in. However, if there is a global downturn and even higher US inflation then the USD can keep gaining as bond markets can keep selling. So the verdict needs to be to keep flexible and keep an eye on inflation data. The EURUSD may yet have some more downside ahead. The major levels are below.