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USD surged, Dow, Gold slumped after a hawkish hike by Fed

calendar 21/09/2022 - 20:46 UTC

On Wednesday, all focus was on the Fed policy meeting and SEP (Summary of Economic Projections) or dot plots for the Fed’s thinking about rate actions in 2023. On Wednesday, as unanimously/highly expected, Fed hikes all key rates by +0.75% and projected terminal rate +4.50% (~4.4: median 4.50-4.25) at Dec’22 and +4.75% (~4.6: median 4.75-4.50) at Dec’23. Thus, as per September SEP, Fed may hike another +125 bps to reach a +4.50% terminal rate by Dec’22; i.e. Fed may hike another +75 bps in November and +50 bps in December. This is more hawkish than the market expected. And subsequently, USD surged, while Dow, and Gold slumped. But at the same time Fed also projected only +25 bps hikes in the entire 2023, which is less hawkish than the market assumption. Subsequently Dow, Gold recovered and briefly made day high as a knee-jerk reaction.

In any way, Dow stumbled again along with Gold to some extent as, during his presser/Q&A, Powell eventually acknowledged the high probability of all-out stagflation for the U.S. economy in 2023 (higher inflation, lower economic growths and higher unemployment) as-well-as housing recession. As usual, Powell also downplayed longer-term SEP of more than 3/6/12 months. Thus the market got some hints that if inflation does not come down meaningfully, then Fed has to again go for rate hikes for a positive real rate by H1CY23, even at a lower pace.

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 CPI inflation +5% by H1CY23, Fed may hike to at least +5.25% by H1CY23, 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.

Full text of FOMC statement:

September 21, 2022

Federal Reserve issues FOMC statement

Recent indicators point to modest growth in spending and production. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.

Russia's war against Ukraine is causing tremendous human and economic hardship. The war and related events are creating additional upward pressure on inflation and are weighing on global economic activity. The Committee is highly attentive to inflation risks.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 3 to 3-1/4 percent and anticipates that ongoing increases in the target range will be appropriate. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt, and agency mortgage-backed securities, as described in the Plans for Reducing the Size of the Federal Reserve's Balance Sheet that was issued in May. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michael S. Barr; Michelle W. Bowman; Lael Brainard; James Bullard; Susan M. Collins; Lisa D. Cook; Esther L. George; Philip N. Jefferson; Loretta J. Mester; and Christopher J. Waller.

September 21, 2022

Implementation Note issued September 21, 2022

Decisions Regarding Monetary Policy Implementation

The Federal Reserve has made the following decisions to implement the monetary policy stance announced by the Federal Open Market Committee in its statement on September 21, 2022:

The Board of Governors of the Federal Reserve System voted unanimously to raise the interest rate paid on reserve balances to 3.15 percent, effective September 22, 2022.

As part of its policy decision, the Federal Open Market Committee voted to authorize and direct the Open Market Desk at the Federal Reserve Bank of New York, until instructed otherwise, to execute transactions in the System Open Market Account in accordance with the following domestic policy directive:

"Effective September 22, 2022, the Federal Open Market Committee directs the Desk to:

Undertake open market operations as necessary to maintain the federal funds rate in a target range of 3 to 3-1/4 percent.

Conduct overnight repurchase agreement operations with a minimum bid rate of 3.25 percent and with an aggregate operation limit of $500 billion; the aggregate operation limit can be temporarily increased at the discretion of the Chair.

Conduct overnight reverse repurchase agreement operations at an offering rate of 3.05 percent and with a per-counterparty limit of $160 billion per day; the per-counterparty limit can be temporarily increased at the discretion of the Chair.

Roll over at auction the amount of principal payments from the Federal Reserve's holdings of Treasury securities maturing in each calendar month that exceeds a cap of $60 billion per month. Redeem Treasury coupon securities up to this monthly cap and Treasury bills to the extent that coupon principal payments are less than the monthly cap.

Reinvest into agency mortgage-backed securities (MBS) the number of principal payments from the Federal Reserve's holdings of agency debt and agency MBS received in each calendar month that exceeds a cap of $35 billion per month.

Allow modest deviations from stated amounts for reinvestments, if needed for operational reasons.

Engage in dollar roll and coupon swap transactions as necessary to facilitate settlement of the Federal Reserve's agency MBS transactions."

In a related action, the Board of Governors of the Federal Reserve System voted unanimously to approve a 3/4 percentage point increase in the primary credit rate to 3.25 percent, effective September 22, 2022. In taking this action, the Board approved requests to establish that rate submitted by the Boards of Directors of the Federal Reserve Banks of Boston, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Kansas City, and Dallas.

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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 +3.25%. Thus Fed has to hike another +1.75% by Mar’23; i.e. +75 bps in Nov’22, +50 bps in Dec’22, and then +25 bps each in Jan-Mar’23.

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