FXMAG.COM: For now market consensus points to a 25bp rate hike, what’s behind such a scenario?
In order to understand the strong consensus for a 25bp rate hike we may look at the possible reasoning behind such a decision and combine it with the method of exclusion to confirm our rationale.
The Federal Reserve has indicated that its key priority is to drive down the inflation represented by the personal consumption expenditures (PCE) price index and, to a lesser extent, the consumer price index (CPI) while keeping the unemployment rate reasonably low. We can have a closer look at these measures to understand how well the current policy has been working.
Historically, the PCE price index has been lower than the CPI one due to the different weights and groups of goods and services. As an example and reference point, from January 1995 to May 2013, CPI in the US was registered at 2.4% while PCE was 2.0% - largely in line with the target of 2.0%. In recent months, however, both indices have lowered from their highest levels in 2022 but are still considerably higher than this target. The core PCE price index's highest point was reached in February 2022 at 5.3% and it has been highly persistent despite the rising interest rate environment. If we assume the inflation target of 2.0% and the latest PCE price index of 4.6% in February, the Fed has managed to drive the inflation down only by 0.7 percentage points or 21% of the whole way to go. CPI, on the other hand, has seen a stronger decline since its highest number of 9.1% in June 2022. With the latest available CPI data of 5.0% and using it as the gauge for inflation we may consider that the Fed is more than halfway to returning inflation to its target of 2.0%. Considering the above facts, while also recognizing that Fed decisions may take longer to realize in the real economy, it may be likely that the point where no further interest rate hikes are needed may not yet be reached.
Looking at the unemployment rate in the US, in January 2023 it fully recovered to the pre-pandemic level and reached its lowest level in more than 50 years at 3.4%. The latest available reading of the unemployment rate in March showed just a 0.1% percentage point increase from the historical low suggesting that the Fed may still see some room to allow the unemployment rate to increase in exchange for driving the inflation down to its target.
We should also recognize that interest rate decisions are closely related to the national currency and its strength against other currencies. Taking into account that other major economies, such as the eurozone and the UK are lagging in terms of raising interest rates (they started raising interest rates later than the US and their key interest rates are currently lower than those of the US) as well as less successful in fighting inflation (latest CPI reading showed that inflation in the UK is still above 10%), it is possible that the ECB and BoE may have to continue raising interest rates also after the US commences its rate hiking cycle. This may result in the US Dollar losing strength against currencies in those economies where interest rates are still being raised. If we assume that the Fed is not willing to let the US Dollar slip further against other currencies, it may be motivated to keep interest rates higher for longer.
Combining all the above reasonings in favor of the continuation of raising interest rates with the fact that in the previous two meetings FOMC elected to raise interest rates by 25 bp, a reasonable scenario for the May 3 meeting would be to continue the trend and raise the interest rates by the same amount to 5.00% - 5.25%. A higher increase may send a too bearish signal to the economy provoking a sell-off in the financial markets. And considering that the inflation is going in the right direction, there may be no sufficient reasoning for the Fed to reverse the trend of 25 bp interest rate hikes to larger ones.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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