- On 15 June, the Federal Open Market Committee (FOMC) raised the federal funds rate target range by 75 basis points (bps) to 1.50%-1.75%. This was the largest single meeting increase since 1994. One FOMC member dissented, preferring a 50bp rate hike.
- The committee remains “strongly committed” to returning inflation to target. We expect the FOMC to remain on an aggressive tightening path and retain maximum flexibility in both the size and number of rate hikes.
- The Fed made no adjustment to its planned balance sheet reduction. As a result, we continue to expect that quantitative tightening (QT) will not have a material impact on short-term credit markets in the near-term. We do expect QT to lower bank reserves, where deposits generally carry lower Fed monetary policy beta than money market funds.
- Global Liquidity portfolios are well-positioned to capture the uplift in overnight rates and stand to benefit from continued tightening by the FOMC, with net yields expected to rise materially over the balance of the year.
June FOMC highlights
The FOMC matched market expectations for a 75bp increase to its target range, which now sits at 1.50%-1.75%. It also raised the Interest on Reserve Balances (IORB) and the overnight Reverse Repo Rate (RRP) by an equivalent amount to 1.65% and 1.55%, respectively. Notably, Esther George (a known hawk) dissented, favoring a smaller 50bp increase.
Leading into the FOMC’s June meeting, Committee members had guided the market to a 50bp increase. However, the highest inflation print in the last 40 years, along with an “eye-catching” increase in the University of Michigan’s forward inflation expectation survey data, prompted the Fed to deviate from earlier guidance to a more hawkish 75bp rate hike. During the press conference, Chairman Jerome Powell noted that the rate increase was “unusually large,” and that such an increase should not be “common.” Powell also emphasized the FOMC’s commitment to fighting inflation and stated that either a 50bp or 75bp hike in July “seems most likely.”
The market’s initial reaction to the statement was fairly muted relative to the move earlier in the week, when it shifted from fully pricing in 50bp to 75bp within a few trading sessions. This was an uncommon shift in market expectations during the Fed’s pre-meeting communications blackout window. The market currently estimates the Fed to raise rates by around 200bps this year and has continued to price in more aggressive tightening after each successive FOMC meeting given the inflationary backdrop (Fig 1).
Figure 1: Fed funds futures implied overnight rate time series
The so-called “dot plot” was also updated at this meeting and offered some additional insight into the Fed’s expected rate hike path. FOMC participants now estimate a target rate of 3.375% at the end of 2022, which implies about 175bps in additional tightening this year. There are a number of scenarios that could ultimately deliver 175bps over the remaining four FOMC meetings in 2022, but on average, the dot projections imply a bit less than 50bps a meeting. In a scenario where the Fed raises rates 75bps again at the July meeting, the dots would imply a tapering of rate hike increments into year-end. The dots project a target rate of 3.75% at the end of 2023, with a decline in 2024 to 3.375% as the Fed attempts to manufacture a soft landing. The long run neutral rate forecast remained relatively unchanged at 2.5%.
On the balance sheet, the Fed chose not to make any adjustments to its QT plan, and assets will continue to roll off at an initial pace of $47.5bn a month ($30bn treasuries and $17.5bn mortgages). In September, the monthly QT pace will peak at $95bn a month ($60bn treasuries and $35bn mortgages) and continue at that pace thereafter. As such, the initial impact on money market rates should be minimal, but we do expect QT to lower bank reserves, where deposits generally carry lower Fed monetary policy beta than money market funds.
This week’s FOMC action is welcome news for money market investors and moves us firmly past the most recent zero rate policy era in the US. The short average maturity of money market funds and substantial positions held in overnight to one week maturities will mean a rapid pass-through of higher Fed policy rates in the coming days and weeks. Global Liquidity portfolios are well-positioned to capture the uplift in rates and stand to benefit from continued tightening by the FOMC, with net yields expected to rise materially during the rest of the year.