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Dow plunged as Fed may hike another 275 bps by H1CY23

calendar 20/09/2022 - 19:59 UTC

Wall Street Futures plunged Tuesday ahead of Fed (Wednesday) on the concern of faster tightening as Fed may hike another 175 bps by Dec’22 to +4.25%. And not only the Fed, but on the other side of the Atlantic ECB is also set to hike another +150 bps cumulatively by Dec’22 to take the terminal repo rate +3.00%. As a result, the U.S. as well as the European market is under stress.

Wall Street is under stress on the concern of another jumbo hike of at least +0.75% after hotter-than-expected August inflation data. Fed may further hike cumulative +1.75% for the rest of 2022; +75 bps in September followed by +50 bps each in November and December (depending upon the inflation trajectory) to reach +4.25% terminal rate by Dec’22.

Moreover, Fed will publish SEP/dot-plot on 21st September. Fed may continue to hike either at +50 or +25 bps to reach a positive real rate by H1CY23 at least wrt core PCE inflation, which was +4.6% in July’22. Assuming core PCE inflation around +4% and core inflation +5% by H1CY23, Fed may hike to at least +5.25% by H1CY23 (@+25 bps in 4 months), so that core PCE inflation goes down to +2% levels by H1CY24, ahead of Nov’24 U.S. Presidential election without causing an all-out recession.

Financial (Wall Street) stability is also an unofficial mandate for the Fed besides price stability, especially ahead of the Nov’22 U.S. mid-term election. Fed Chair Powell is under immense pressure from the White House as well as some Democrat Senators to bring down inflation without causing outright inflation before Nov’24 election through calibrated tightening.

As the underlying U.S. economy is still sufficiently strong, Fed has no problem in going for another jumbo hike of +0.75% on 21st September, followed by at least +0.50% each in November and December (if not +0.75%). Fed is now clearly behind the inflation curve and scrambling for a real positive interest rate (at least wrt core inflation) by H1CY23 without causing an all-out recession. But the U.S. economy is already under synchronized global stagflation.

On Tuesday, sensing probable Fed hikes of +75 bps Wednesday, ECB President Lagarde also indicated a similar pace of rate hikes in October and December. Lagarde said:

·         Rates will be decided by the ECB on a meeting-by-meeting basis

·         Taking anchored pricing predictions for granted is not a good idea

·         I anticipate raising interest rates further

·         The rate at which our cycle of increases stops must be compatible with inflation persistently reverting to our aim

·         The Eurozone is not experiencing demand-led overheating like the United States

·         Moving more quickly at the beginning of the hiking cycle demonstrates our dedication

·         If energy prices remain persistently high during the transition, it may have an impact on industrial production

·         Rate rises have been frontloaded by the ECB

·         Inflation expectations remain relatively well anchored across a range of measures

·         Inflation is much higher and more persistent than expected

·         The magnitude of the moves we take and where rates ultimately land will depend on how the inflation outlook changes as we move forward

·         If there is evidence that high inflation risks de-anchoring inflation expectations, the policy rate compatible with our target would be restrictive

·         We won't allow this period of high inflation to influence economic behavior and lead to a persistent inflation issue

 

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Conclusions:

Inflation will not come down meaningfully unless the resolution of supply chain disruptions caused by lingering Russia-Ukraine/NATO/U.S. war/proxy war. As of now, there are no signs of any resolution of this geopolitical conflict. Moreover, Russia/Putin is seeing the supply chain disruptions, subsequently elevated inflation, and resultant stagflation/recession as a golden opportunity to end western supremacy. On the other side, Biden is also not ready to make any compromise with ‘killer’ Putin for domestic political compulsion (until at least Nov’22 mid-term election). Thus Wall Street is now bracing for an all-out recession in the coming days and plunging.

As per Taylor’s rule:

Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.50+2+ (1.25+0)*(4-2)

=0.50+2+1.25*2=0.50+2+2.5=5%

Here for the U.S.

A=desired real interest rate=0.50; B= inflation target =2; C= permissible factor from deviation of inflation target=1.25 (2.5/2); D= permissible factor from deviation of output target from potential=0; E= average core CPI (PCE inflation) = 4

As per Taylor’s rule, which Fed policymakers generally follow, assuming U.S. ideal real interest at 0.50%, the Fed repo/interest rate should be +5.00% against the present +2.25%. Thus Fed has to hike another +2.75% by June’23.

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