Federal Reserve saw risk that rate hikes could slow economy more than expected: FOMC minutes

Douglas Rissing

Federal Reserve policymakers discussed downside risks to GDP growth, including the possibility tightening financial conditions “would have a larger negative effect on economic activity than anticipated,” according to the minutes of the Federal Open Market Committee’s July 26-27 meeting. In other words, its rate hikes could tip the U.S. economy into recession.

Other downside risks included more pandemic-related disruptions or that “geopolitical and global economic developments would lead to additional adverse economic or financial disturbances.”

Still, the minutes conveyed a decidedly hawkish tone.

And while the July 75 basis point rate hike brought the nominal federal funds rate to within the range of the policymakers’ estimates for the longer-run neutral rate, “with inflation elevated and expected to remain so over the near term, some participants emphasized that the real federal funds rate would likely still be below shorter-run neutral levels after this meeting’s policy rate hike.”

Indeed, the FOMC considered that moving to a restrictive stance will be needed to meet its legislative mandate to promote maximum employment and price stability. As Fed Chair Jerome Powell had said during his post-meeting press conference, the Fed officials “continued to anticipate that ongoing increases in the target range for the federal funds rate would be appropriate to achieve the committee’s objectives.”

Update at 3:39 PM ET: When reading through the minutes, two things stood out for Don Calcagni, chief investment officer at Mercer Advisors: a tone that was softer than expected and the comment that its policy rate range was close to the neutral level — the point at which the rate neither hinders nor fuels economic growth. The second point “suggest that perhaps the Fed will be taking its foot off the brake,” Calcagni said in an interview with Seeking Alpha.

Others in the market likely noticed that implication as well. The probability of a 75 basis point rate increase at the September Fed meeting edged down to 38.5% from 41.0% a day earlier, according to the CME FedWatch tool. Conversely, the probability of a 50-bp hike increased to 61.5% from 59.0% on Tuesday.

“I think that 50 bps is in the cards,” Calcagni said. Furthermore, “I don’t think 25 bps is off the table.” There “a lot of ambiguous” economic data he pointed out, with jobs data exhibiting strength but retail data and inventory buildups providing evidence of “a rapidly slowing economy… Arguments can be made that that the Fed should be moving a lot slower.”

The committee’s discussion showed no sign that it might start cutting the federal funds rate target range in the next few meeting. “Some participants indicated that, once the policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time to ensure that inflation was firmly on a path back to 2%,” the minutes said.

After the minutes were released, U.S. equity markets initially pared losses markedly. Since then, all three major indexes are about where they were before the minutes were released The Nasdaq -1.1% at 3:44 PM ET compared with -1.2% before 2PM, the S&P is down 0.6% vs. 0.7% before 2 PM ET, and the Dow, which had been down 0.4%, is down 0.5%.

The 10-year Treasury yield slipped to 2.89% vs. 2.91% earlier, and the 2-year yield fell to 3.28% from 3.34%.

In discussing economic conditions, the FOMC members observed that some consumer spending, production and housing activity had softened since their previous meeting. However, job gains stayed strong and the unemployment rate remained low.

The Fed officials expect that U.S. real GDP will grow in the second half of the year, “but many expected that growth in economic activity would be at a below-trend pace” due to tighter financial conditions.

While the Fed’s surveys by its Open Market Desk. found that market participants saw increased odds of a recession in coming quarters, the FOMC minutes don’t use the word recession in the officials’ discussion of the economic outlook.

Recall that at the meeting, the Fed hiked its key rate by 75 bps for second time in effort to tame inflation, bringing the federal funds rate target range to 2.25%-2.50%.

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