May FOMC highlights

The FOMC unanimously decided to make no changes to the 5.25%-5.50% federal funds target range for the sixth consecutive meeting. Interest on reserve balances (IORB) and the overnight reverse repurchase (RRP) rate was also left unchanged at 5.40% and 5.30%, respectively. The decision to leave rates untouched was anticipated by the market, which left the press conference and statement as the focal points of the discussion.

The Statement

The statement underwent two key changes to acknowledge that progress on inflation has recently moved in an unfavorable direction. The committee added the sentence “In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective”. There was also a change in the second paragraph which previously stated that the risks to achieving its employment and inflation goals “are moving into” a better balance to now “have moved toward”. Once again confirming that recent inflation data has reduced their confidence that inflation is moving towards 2%. The committee continued to recognize that growth has “continued to expand a solid pace”, jobs gains have “remained strong “and inflation has “eased” but remains elevated.

The Committee also amended QT beginning in June. The caps of QT will be reduced on Treasury securities from $60 billion a month to $25 billion a month.  While the cap on agency and agency mortgage-backed securities will remain in place at $35 billion a month.

The Press Conference

On the podium, Chair Powell reinforced the committee’s beliefs that the policy rate is sufficiently restrictive to bring inflation back to 2% over time, suggesting that we are at peak policy rate for the cycle. He mentioned that “evidence shows pretty clearly that policy is restrictive and is weighing on demand”. He said the main focal point of discussion has been centered on how long to keep the policy rate restrictive, therefore implying the Fed is discussing a higher for longer view on the policy rate.   

Given the recent repricing of forward rate expectations and stalling progress on the inflation data. The notion of rate hikes has begun to creep into the minds of many investors and economists. Powell was explicitly asked about the potential of rate hikes and expressed that it is “unlikely” as the committee believes that rates are sufficiently restrictive. Their discussion has centered on holding the current level of rates restrictive as opposed to if it is restrictive enough, declining to engage in the rate hike scenario hypothetical.

Regarding rate cuts, Powell offered up that he sees two paths. The first path is if the committee is able to gain greater confidence that inflation is sustainably moving towards 2% and as of now they are “not gaining greater confidence”. The second path would be if the labor market begins to deteriorate in a noticeable fashion. Powell mentioned if the labor market data started to show a “significant rise in unemployment rates or a sudden drop in job creation” , the committee could begin to make the case that rate cuts are necessary to bolster the economy. 

Quantitative Tightening

The Fed announced it would begin to taper their Quantitative Tightening program by reducing the caps for the runoffs of Treasury and agency securities. The initial plan which was released during the May 2022 FOMC meeting and set the caps at $60 billion and $35 billion per month, respectively. The FOMC announced the new cap beginning in June would be $25 billion for Treasury Securities while leaving agency debt and agency mortgage-backed securities unchanged at $35 billion a month. This will slow the decline in the System Open Market Account (SOMA) securities holdings which has decreased by approximately $1.53 trillion since peaking in April 2022.

The Fed potentially decided to taper in large part due to the decline in the overnight reverse repurchase (RRP) which over the past year has decreased significantly as money market funds have chosen to invest in T-bills funded by their RRP balances. One reason driving this decision is that the Fed is attempting to avoid potential stress in money markets space caused by reserve tightness. If the money markets begin to experience a period of stress that could potentially force the Fed to end their goal of normalizing their balance sheet and achieving the level of ample reserves. By slowing the pace of runoff, the Fed will allow market participants to better digest the effects of the reserve drain and thus allow for a smoother transition. 

Implications for investors

USD money market investors should continue to benefit from elevated rates at cycle highs. The market has pushed back the timing and the pace of future rate cuts and our funds are well-positioned to take advantage of the repricing. We expect fund yields to remain highly competitive in the current environment, and duration extensions today will keep them competitive when monetary policy eventually eases down the road. With that said, inflation is an unsettled matter and we will be incremental with duration adds.