The Federal Reserve is primed to hike rates by another 0.75% at its meeting in July. That would put the fed funds rate in a range of 2.25-2.5%, close to what is considered neutral but not tight monetary policy.
That shift, coupled with the Fed decision to shrink its bloated balance sheet, makes the current tightening cycle the most rapid since the 1980s. No one, including the Federal Reserve, knows exactly how reductions in the balance sheet, aka quantitative tightening (QT), will affect credit markets.
The Fed is now stuck between a rock and a hard place, with no easy way out without the economy feeling pain. Fed Chairman Jay Powell has started to underscore that reality by admitting a recession could occur.
This is at the same time that we will likely get the second quarter in a row of negative real GDP growth, which is, loosely, how many define a recession. An official recession would require a rise in unemployment, which the Fed has admitted is necessary for inflation to come down.
Kansas City Fed President Esther George dissented at the June meeting, opting in favor of a more measured 0.5% hike in rates. She is worried about the destabilizing effects that rapid rate hikes could have on the economy, both at home and abroad.
She is not alone in her concern. Voting members of the FOMC usually do not dissent in a vacuum. They often cast a vote reflecting the views of those who agree with them but are not in a position to vote at a given meeting.
The Fed will discuss a full percent but will likely stay with a 0.75% hike. We could potentially see more than one dissent. Some may favor a full percentage point hike, while others favor a half percentage point hike.
Why such dissonance? The Fed has a diverse set of views; it is in uncharted waters. Uncertainty and disagreement about the course of rate hikes is a natural consequence.
The July meeting will be the first fully staffed FOMC meeting since 2013. The entire Board of Governors has been sworn in, while new regional presidents have been named to fill vacant posts. That adds to the level of debate.
The Fed is the de facto central bank to the world. Rate hikes here have to be matched with rate hikes elsewhere. This is pushing up debt service costs at the same time many countries cannot afford to pay for food and energy. Sri Lanka's default was extreme but provides a cautionary tale. Other defaults are possible. China is not in the position it once was to help; it provided a loan to Pakistan to help it meet debt obligations in April.
Now add the collapse of Italy’s government and the need for the ECB to contain fragmentation - a blow out of debt spreads within the eurozone - even as it raises rates. These challenges along with turbulence in emerging markets make the Fed’s job more complex. There is no Las Vegas in the global economy: what happens elsewhere does not stay there.
The Fed's greatest nightmare is that it accidently hits a trip wire that triggers a seizure in credit markets. That could force it to intervene to prevent a fully fledged economic meltdown before inflation has been tamed.
The Fed wants to avoid a repeat of the stop-and-go policies that fueled the stagflation of the 1970s but may not have a choice. I don’t envy its job. Rising rates are revealing a multitude of sins.
The Fed’s greatest nightmare is that it accidently hits a trip wire that triggers a seizure in credit markets.
