The Fed Capitulates

The Fed raised interest rates by 75 basis points in its June policy meeting, acknowledging continued upside surprises on inflation, inflation expectations and wage growth. It also de facto abandoned forward guidance. It was a reminder that economic data eventually rule the day, says Franklin Templeton Fixed Income CIO Sonal Desai. She argues this is a welcome but only partial move to a more realistic stance, and discusses why further hawkish surprises likely lie ahead.

The US Federal Reserve (Fed) has capitulated to the data and in my view, has opened the door to a slightly more realistic assessment of the inflation and policy outlook.

Fed Chair Jerome Powell this week took the podium in a very weak position. The Fed had badly mismanaged communication ahead of this week’s Federal Open Market Committee (FOMC) meeting: it had telegraphed a 50 basis point (bp) hike but at the last minute signaled the larger 75 bp hike it then delivered—and which had therefore been largely priced in by markets. Upside surprises on headline Consumer Price Index (CPI) and inflation expectations had badly shaken the credibility of FOMC forecasts and of the moderate policy tightening that had been foreshadowed in last month’s meeting.

The FOMC outcome was a timely reminder that economic data eventually rule the day. In my view, the post-meeting press conference delivered a clear warning that investors should be prepared for further hawkish surprises. Powell acknowledged that the recent rise in inflation expectations had played a key role in swinging the decision to a larger hike. He acknowledged that the very tight labor market adds to inflation pressures via robust wage growth. He noted that the Fed is ultimately responsible for headline CPI inflation, and that headline inflation drives inflation expectations. The clear message is that the Fed is now—belatedly—aware that both inflation expectations and wages are adding to inflation pressures and sees inflation risks as skewed to the upside.