Another Giant Step Expected from Fed, Key is December... Depends on Powell's Words

[Image source=Reuters Yonhap News]

[Asia Economy New York=Special Correspondent Joselgina] Ahead of the November Federal Open Market Committee (FOMC) regular meeting of the U.S. Federal Reserve (Fed), which influences global monetary policy, investors' attention is focused on Fed Chair Jerome Powell's remarks. With an additional giant step (a 0.75 percentage point increase in the benchmark interest rate) widely expected at this meeting, the key issue is the size of the rate hike at the last meeting of the year in December. The market is looking to Powell's press conference for signals of a slowdown in the pace of tightening.

◆High-Intensity Tightening vs. Pace Adjustment at December FOMC

According to the Chicago Mercantile Exchange (CME) FedWatch on the 31st (local time), the federal funds (FF) rate futures market currently reflects an over 89% probability of a giant step at the November 1-2 FOMC regular meeting. In this case, the U.S. benchmark interest rate would be 3.75% to 4.00%. For December, the probabilities of a giant step and a big step (0.5 percentage point increase) are nearly tied at around 47% each.

As inflation remains stubbornly high, there is a view that the Fed will continue with high-intensity rate hikes. On the other hand, there is speculation that the Fed may begin to adjust the pace to avoid unnecessary economic recession caused by excessive tightening.

U.S. economic media CNBC reported that many Wall Street investors are looking for signals at Powell's press conference on the 2nd that the Fed might soon pause rate hikes or reduce the size of increases. The dot plot showing FOMC members' rate path projections will not be released at this meeting, making Powell's remarks even more critical for investors.

Quincy Crosby of LPL Financial said, "Wednesday's (the 2nd, when the FOMC statement and Powell's press conference take place) message will play a decisive role in future market expectations," adding, "Powell will need to carefully craft his answers during the press conference to avoid misinterpretation." Jake Jolly, Chief Investment Strategist at BNY Mellon, also noted, "The most important thing is how much Powell says about December," and added, "If Powell remains relatively quiet and does not discuss his thoughts, it could be interpreted as hawkish." This also implies that decisions will depend on data.

For Powell, the risk that consecutive giant step policies might overwhelm the economy at once cannot be ignored. Inside the Fed, concerns about the size of future rate hikes have been confirmed, including from Vice Chair Lael Brainard.

Another signal the Fed cannot ignore is the recent persistent inversion between the 10-year and 3-month Treasury yields, considered a precursor to recession. Michael Wilson of Morgan Stanley pointed out this short- and long-term yield inversion, stating, "It suggests that the Fed's policy shift could come sooner than expected."

Moreover, the 10-year to 3-month yield spread is regarded as a more emphasized indicator by the Fed than the 10-year to 2-year yield trend. According to analysis by economist Arturo Estrella, a former New York Federal Reserve Bank official, since the late 1960s, recessions have always occurred within 6 to 15 months after the inversion of the 3-month and 10-year yields. Concerns about corporate earnings for 2023 also support this pace adjustment theory.

However, if Powell signals a pace adjustment in December at this meeting, there is concern that it could send a signal to the market that the Fed is retreating in its fight against inflation. Previously, Powell's July press conference was interpreted dovishly, leading to a market rally, after which he emphasized a super-hawkish tightening stance in his August Jackson Hole speech to avoid sending the wrong signals.

Therefore, the market expects that if Powell decides to slow the pace of rate hikes while inflation indicators remain high, he may cite a slowdown in wage growth as the rationale.

The New York Times (NYT) reported, "If the Fed's efforts to lower inflation negatively impact the economy, it could face the same backlash that former Chair Paul Volcker encountered," adding, "Powell might avoid repeating Volcker's path and reduce the rate hike to 0.5 percentage points in December." Conversely, Bloomberg mentioned that corporate earnings declines in the recent third-quarter reports were not as severe as feared, stating, "Fed tightening could accelerate. Excessive optimism should be cautioned against."

◆Fed Also Suffers Losses from Rate Hikes: "Interest Losses Exceed Earnings"

Reports have also emerged that the Fed itself is suffering significant losses due to rate hikes. The Wall Street Journal (WSJ) reported that the interest the Fed pays to commercial banks and money market funds (MMFs) has recently exceeded the interest income earned from its bond holdings, increasing the Fed's losses over the past few weeks.

According to WSJ, the average yield on U.S. Treasury bonds and mortgage-backed securities (MBS) purchased by the Fed over the past 14 years through quantitative easing is 2.3%. The Fed sends the interest income generated from its holdings to the Treasury Department, which amounted to $107 billion last year alone. James Bullard, President of the Federal Reserve Bank of St. Louis, confirmed to reporters last month, "We have sent nearly $1 trillion to the Treasury over the past decade." However, he added, "Now that interest rates have risen, the situation is changing."

If an additional giant step is decided in November, the Fed's net interest losses will inevitably increase further. Barclays forecasts that the Fed's net interest losses could reach $60 billion next year, with losses of $15 billion in 2024 and a return to profitability only in 2025. Barclays noted, "This will not affect the Fed's monetary policy," but warned, "Because of its size and novelty, it could cause political headaches."

WSJ stated, "Over the past decade, the Fed earned substantial interest income from its bond holdings due to relatively low interest rates," but now "it is paying more in interest expenses than it is receiving in interest income."

This content was produced with the assistance of AI translation services.