Fed forecasts point to rate hikes in 2023; QE tapering discussion to get underway in earnest at future FOMC meetings
The key event over the past 24 hours was, of course, the Fed’s FOMC policy announcement, revised economic and policy projections and Chair Powell’s post-meeting press conference.
As expected, the committee held the target fed funds rate at 0-¼%. But as was not particularly unexpected, the Fed increased the interest rate on reverse repos and the interest rate on required and excess reserves by 5bps to 0.05% and 0.15% respectively. These are technical adjustments, designed simply to modestly lift other money-market interest rates and prevent them from moving into negative territory.
Looking ahead, as previously, the Fed continues to say that the current target fed funds rate will be appropriate until labour market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time. However, whereas previously only seven of the 18 FOMC participants had expected at least some policy tightening in 2023, now 13 of 18 participants expect at least one 25bp tightening in that year with the median participant expecting two 25bp hikes. Notably, five of the 18 participants expect four 25bps hikes or more. Moreover, seven of the 18 participants expect an even earlier lift-off in 2022, up from just four previously.
Of course, as Powell emphasised, these are the forecasts of individual Fed policymakers, rather than a Fed ‘plan’, and what the Fed does eventually will depend on how the economy evolves. For now, the median participant expects GDP growth of 7.0% this year, up from 6.5% previously. However, forecast growth of 3.3% and 2.4% in the subsequent two years was almost unchanged from that projected in March. The Fed’s forecasts for the unemployment rate across all three years were virtually identical to March, with the unemployment rate expected to end this year at 4.5% and move below its assumed long-run level of 4.0% in the subsequent two years.
Unsurprisingly, the largest revisions were saved for the Fed’s inflation forecasts, with this year’s forecast for headline inflation lifted 1.0ppt to 3.4%. The forecast for core inflation this year was lifted 0.8ppt to 3.0%, but inflation is forecast to decline to 2.1% over each of the subsequent two years (the forecast for next year just 0.1ppt higher than in March, while the forecast for 2023 was unchanged). Overall, these revisions seem minor considering the change in policymakers’ outlook for policy. However, importantly, the detailed projections indicate that policymakers now view the risks around their inflation forecasts as lying to the upside, compared with the balanced assessment offered back in March. And in his press conference, Jay Powell suggested that inflation expectations and the broader improvement in the labour market might be stronger then.
Aside from the outlook for the fed funds rate, the other key point of interest yesterday concerned the future of the Fed’s QE programme. For now, the programme is unchanged, with the committee signalling that it will continue to increase its holdings of USTs by at least $80bn per month, and of agency MBS by at least $40bn per month, “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals”. During the press conference, Powell remained evasive regarding what that ‘substantial further progress’ looks like in practice, but he did say that the Fed still thinks it ‘a ways away’. However, he did confirm that policymakers have now begun to talk about this issue (or at least ‘talk about talking about’ as Powell quipped) and that this would continue over coming meetings with the discussion to be guided by the incoming data. As in the past, he confirmed that the market would be given ample advance notice ahead of any decision to taper purchases. Daiwa America’s Chief Economist Mike Moran suggests that tapering of Treasury purchases will likely begin in the New Year, but would not be surprised if the Fed began tapering its MBS purchases late this year.
Fed drives bond yields higher, lifts greenback but weighs on equity markets
Unsurprisingly, the price action in US markets on Wednesday was dominated by reaction to the Fed. Treasury yields had traded sideways ahead of the meeting. However, with the Fed’s message clearly less dovish than the market was expecting, the 10Y UST lifted 8bps to 1.58%, thus returning to levels not seen since the first week of June. While the lift in yields gave the greenback a solid boost, it weighed somewhat on a stock market that was already a touch weaker ahead of the Fed’s announcement. After being down as much as 1% at one point, the S&P500 pared its losses to close down just 0.5%. However, US equity futures have declined up to ½% since the close.
Against that background, it has mostly been a softer day for equity markets in Asia. China bucked the trend, with the CSI300 climbing very modestly following three days of losses (including 1.7% yesterday), with investors perhaps viewing yesterday’s softer-than-expected domestic activity indicators as a constraint on PBoC policy tightening. In Japan, ahead of tomorrow’s BoJ policy announcement, the TOPIX declined 0.7% even as the resurgent greenback pushed ¥/$ towards 111. In local news, PM Suga will hold a press conference at 7pm local time to formally announce that he will end the state of emergency in Tokyo and other prefectures as planned on 20 June. According to reports, a quasi-state of emergency will still be applied thereafter to seven prefectures, with early closing restrictions remaining for bars and restaurants and alcohol to be served ‘with precautions’.
Given developments in the UST market, it was always going to be a tough day for investors in the Antipodean bond markets. But the Fed-inspired sell-off has been reinforced by unexpectedly strong local news, with Australia’s unemployment rate unexpectedly plunging 0.4ppt in May to its pre-pandemic level of 5.1% and New Zealand’s GDP growing 1.6%Q/Q in Q1 when the RBNZ had forecast a contraction in activity. As a result, while RBA Governor Lowe had maintained a relatively dovish line in a speech given ahead of the data, Aussie 10Y yields have jumped 10bps to 1.64%, with the November 2024 bond yield rising 11bps to 0.38% as any thought of the RBA rolling its 3Y yield target was finally extinguished. In New Zealand, the 10Y yield jumped 13bps to 1.77%, with markets now pondering whether the RBNZ will deliver policy tightening even sooner than forecast then the H222 timeframe entertained last month. The lift in yields provided some support to the Aussie and Kiwi dollars, but weighed on the respective stock markets.
Japan’s Reuters Tankan points to broadly stable business conditions
On balance, today’s Reuters Tankan indicated that the business conditions facing both manufacturing and non-manufacturing firms were stable over the past month. After increasing sharply in prior months, the overall diffusion index (DI) for manufacturers rose just 1pt to 22 in June. This nonetheless marks the best reading since December 2018 and is well above the long-term average (which sits around zero). The forecast DI – which measures expected business conditions three months ahead – was steady at 21, indicating that respondents expect business conditions to remain at similarly favourable levels in the near term. At the industry level, most sectors reported similar business conditions to last month, although respondents in the metal products and auto sectors were a bit more positive, even as those in the sheet metals sector grew more pessimistic (the latter likely reflecting concerns about rising commodity prices).
Despite ongoing restrictions on activity in the hospitality sector, the overall non-manufacturing DI slipped just 2pts to 0 in June, thus remaining a little below the long-term average (which is around 5). The forecast DI fell 3pts to 10, but this still indicates that firms expect a notable improvement in business conditions over the next three months (presumably once pandemic restrictions are eased, and perhaps in anticipation of activity associated with the Olympics). At the industry level, the retailers DI fell 13pts to -22 – the lowest level since May last year – and respondents indicated that they expect business conditions to remain somewhat difficult over coming months. Unsurprisingly, optimism in the information services industry remained sky high, with the DI steady at 60 this month.
China’s home prices continued to rise in May
Following on from yesterday’s somewhat disappointing domestic activity data – albeit still maintaining solid growth – today China released news on developments in home prices during May. New home prices across China’s 70 largest cities increased 0.52%M/M – fractionally more than in April and so the most since August – albeit leaving annual growth steady at 4.5%Y/Y. Existing home prices increased 0.30%M/M, causing annual growth to lift 0.1ppts to 3.5%Y/Y. As in previous months, the largest increases continue to occur in so-called first-tier cities, where existing home prices increased 0.7%M/M and 10.8%Y/Y.
Final euro area inflation data for May ahead; no UK data of note due today
There are no significant data releases ahead in the UK today, with tomorrow’s retail sales report being the next diary entry of note. In the euro area we will receive final inflation data for May. Despite a slight downwards revision in the Italian data, these are expected to align with the preliminary figures and confirm an increase of 0.4ppt in the headline euro area CPI rate, to 2.0%Y/Y, the highest level since October 2018. The preliminary data revealed that the rise was driven principally by energy inflation, which - largely due to base effects - accelerated to (13.1%Y/Y) the highest since October 2008. In contrast, food inflation remained unchanged at 0.6%Y/Y, the lowest rate since November 2016. Prices of non-energy industrial goods rose 0.7%Y/Y, up from April but still a subdued rate to suggest that supply-side pressures were largely absorbed by margins. Services inflation edged up 0.2ppt to 1.1%Y/Y in May, and the preliminary core rate also rose 0.2ppt, to a more subdued 0.9%Y/Y.
Data-watching resumes in the US today
With the Fed out of the way, attention in the US will turn back to the economic data. The Conference Board will print its leading indicator for May, which is likely to register its twelfth increase in the past 13 month to sit some 3% above its pre-pandemic peak. Meanwhile, the Philadelphia Fed’s manufacturing survey for June and the weekly jobless claims report will also be of interest.
Australian employment surges in May, sending unemployment rate down to 5.1%
As far as data were concerned, the domestic focus in Australia today was on the labour market, with analysts expecting a rebound in employment in May following a decline in April that was at odds with other buoyant indicators (including job advertising at a 13-year high). As it turns out, employed surged 115k (0.9%M/M) in May – almost quadruple expectations and easily wiping out the 31k decline registered in April. As a result, combined with base effects associated with last year-year’s lockdown, annual growth in employment jumped to 8.1%Y/Y. More meaningfully, employment now sits 1.0% above the pre-pandemic high registered in February 2020, notwithstanding the expiry of the Government’s JobKeeper programme at the end of March.
In the detail, full-time employment increased by an especially encouraging 97.5k in May. As a result, full-time employment is now up 4.9%Y/Y and 1.1% higher than in February 2020. Part-time employment increased 19.7k in May. While up a whopping 15.7%Y/Y – reflecting the particularly severe impact of the lockdown on this class of work – part-time employment is just 0.8% higher than in February 2020. Amongst the larger states, employment growth was especially strong in was New South Wales (1.8%M/M) and Queensland (1.2%%M/M), but was also very strong in Victoria (0.9%M/M). Meanwhile, aggregate hours worked increased 1.4%M/M in May, and thanks to base effects were up 13.0%Y/Y.
After declining from a record high last month, the labour force participation rate rebounded 0.3ppt to 66.2%. Even so, the increase in the labour force was far outweighed by the increase in employment, causing the unemployment rate to decline by a sharp and unexpected 0.4ppt to 5.1%. At the second decimal place the unemployment rate is now in fact lower than in February 2020 and close to the all-time low of 5% registered on various occasions prior to the pandemic. Meanwhile the underemployment rate – which captures those who are working less hours than they would like or in jobs for which they are overqualified – fell a further 0.3ppt to 7.4%, marking the lowest reading since January 2014.
In its most recent forecasts, the RBA had forecast the unemployment rate to decline to 5¼% by the end of Q2 and 5% by the end of Q4. So with the unemployment rate now already close to the Bank’s year-end forecast, it seems increasingly likely that the RBA will soon need to revisit its view that the conditions required to justify policy tightening will not be met until ‘2024 at the earliest’. In a speech given today ahead of the data, RBA Governor Lowe stated that the Board had viewed scenarios in which the conditions for an increase in the cash rate could be met during 2024, while in other scenarios these conditions were not met. Lowe noted that the Board will review these scenarios again at its next meeting in July, at which it will make decisions on its 3Y bond target and extending its QE programme. In light of today’s data, in our view a policy tightening in 2024 or earlier is now surely the most likely scenario. As a result, it seems even less likely now that the RBA will roll its 3Y yield target to the November 2024 bond, while the argument for paring back the QE programme has surely strengthened too. And at the current pace of improvement, the RBA may well be forecasting a rate hike in 2023 by the time it publishes the next Statement on Monetary Policy in August.
Kiwi GDP expands 1.6%Q/Q in Q1, well above expectations
With partial indicators having improved of late, local analysts had expected today’s Q1 GDP report to reveal a partial unwind of the 1.0%Q/Q contraction recorded in Q4. As it turns out, the favoured production-based measure of activity expanded 1.6%Q/Q – 1.1ppt above the consensus expectation in Bloomberg’s poll and even more distant from the 0.6%Q/Q contraction that the RBNZ had estimated in last month’s Monetary Policy Statement. As a result, annual growth improved to 2.4%Y/Y from -0.8%Y/Y previously. A 2.4%Q/Q increase in activity in the goods sector led the rebound, with construction rising an especially strong 6.6%Q/Q. Meanwhile, activity in the services sector grew a further 1.1%Q/Q.
The expenditure-based measure of GDP grew 1.4%Q/Q, so lifting annual growth to an even stronger 3.6%Y/Y. In the detail, private consumption surged 5.4%Q/Q and 7.3%Y/Y, while business investment increased an especially welcome 8.3%Q/Q and 3.3%Y/Y. Residential investment and government consumption grew 2.3%Q/Q and 1.6%Q/Q respectively. Given these outcomes, GNE grew a whopping 6.3%Q/Q and 9.0%Y/Y in Q1. However, with exports declining 8.0%Q/Q and rampant domestic demand boosting imports by 7.1%Q/Q, net exports made a huge negative contribution to GDP growth in the quarter.
These data are very dated, applying to a period that ended almost three months ago. However, the data clearly suggest that the economy – and especially domestic demand – were on a much firmer footing than the RBNZ had expected when it shifted to much more hawkish rhetoric last month. Needless to say, today’s data will reinforce that shift in view. The focus now will turn to next month’s quarterly employment data, which will cast light on activity in the present quarter and on whether the surprisingly rapid retightening of labour market conditions has been sustained. Any further upside surprises would increase the likelihood of the RBNZ withdrawing stimulus sooner than the H222 timeframe signalled last month.