The Fed's minutes are here.  4 key topics to follow.

The Fed’s minutes are here. 4 key topics to follow.


You can read the minutes of the May meeting of the Federal Reserve System here. Read the preview below and return to further analysis.

When the Federal Reserve publishes the minutes of its last political meeting on Wednesday, investors will take a deeper look at the monetary tightening considerations and officials’ views on the economy.

During a meeting that ended on May 4, the Federal Free Market Committee, a component of the Fed, raised its key currency rate by 0.5%. It was the first increase since 2000. Officials signaled a similar increase in June, and Wall Street expects a further rate increase of 0.5% in July. But what will happen after the June 14-15 meeting is less certain and will depend on inflation, economic growth and financial conditions.

Here are some things to keep in mind this week’s minutes and in the central bankers’ comments before and after the next political meeting.

Financial condition

When Fed officials and economists talk about “financial conditions,” they mean things like stock market levels and corporate bond spreads. These are some of the monetary policy transmission mechanisms that affect households and businesses through the effect of wealth and credit costs.

Financial conditions have tightened sharply since the last Fed meeting. Investors are looking for clues on how much the central bank would like stocks to fall and credit spreads to widen. Deutsche Bank economists note that Fed Chairman Jerome Powell mentioned “financial terms” 16 times at a news conference after last month’s meeting, suggesting that the issue was the focus of the meeting.

“Powell and colleagues have shown a growing focus on tighter financial conditions as a substitute for providing stronger guidance on whether Fed Funds will need to reach a restrictive level over time,” say Deutsche Bank economists, meaning financial conditions are key. to predict how high rates will rise – and when they might start to turn. Economists there and elsewhere say the Fed probably wants financial conditions to tighten, at least for now, given high inflation.

For context, Goldman Sachs economists say their GS US Financial Conditions Index has tightened by about 0.6% to 99.29 over the past week. About a month ago, the metric was 98.64; at the beginning of the year it was about 97.

Inflation

As financial conditions tighten, inflation is still at its peak in four decades. The consumer price index rose by 8.3% in April compared with the previous year, which largely exceeded expectations that inflation would peak. While goods are showing signs of cooling price pressures, shelter inflation is stubborn and rising, necessity costs are high and service prices are rising.

“With stock markets declining and a wider credit spread, the US Federal Reserve is definitely getting what it wanted,” said Katie Nixon, chief investment officer at Northern Trust Wealth Management. “When we have seen these conditions in the past, the speed of these steps has forced the Fed to back away from well-thought-out plans to tighten policies,” he says. But it is unlikely that the Fed will reverse the course now, given how far behind the Fed’s inflation curve it has fallen, says Nixon. “The Fed has called inflation the number one public enemy and risks a crisis of credibility if policy changes at this point,” he said, arguing that dramatic market downturns would not be triggered so easily by the so-called Fed.

The Fed said in its May policy statement that inflationary risks are pro-inflationary, given the shortage of food and energy commodities stemming from the Russian invasion of Ukraine and the Covid-related blockades of China, which have exacerbated supply chain disruptions.

Speaking on May 17, Powell said he wanted “clear and convincing evidence” of falling inflation before slowing rates. This is legal for the second highest standard of evidence and requires that the evidence be highly probable, says Joseph Wang, a former senior trader at the Fed’s Open Markets Department and a lawyer. Traders will look for any change in language and tone around the projected path of inflation and risks to the Fed’s forecasts, which will be further updated in June.

Growth retardation and soft or soft landing

Powell argued that the Fed could make a soft landing – meaning that growth would continue as the central bank tightens monetary policy to fight inflation, and Wall Street mostly agrees. However, this claim has led some market participants to doubt that the Fed will be hard enough on inflation to set a staggering pace of slowing growth and high prices.

Powell’s tone has changed recently. He first used the word “soft” instead of “soft” and said last week that taming inflation could lead to a “bumpy” landing. “There could be some pain,” he warned.

The Fed’s May statement acknowledged the surprise decline in gross domestic product in the first quarter from the previous quarter, but said household spending and corporate fixed investment remained strong. Recent earnings reports from America’s largest retailers have called into question the dominant narrative that because consumers – about 70% of GDP – have amassed trillion-dollar savings during the pandemic – it will prevent the wider economy from falling into recession. Nevertheless, the labor market is very tense. Economists expect the unemployment rate to fall to 3.5% when the May data is published on June 3. This would be half a century before the pandemic and suggests that wage pressures will not ease as employers try to find workers. there are signs of increasing redundancies.

Meanwhile, rapidly rising mortgage rates are slowing housing demand, but prices continue to rise because of insufficient supplies. Rents lag behind house prices by about a year, and shelter accounts for about a third of the CPI, which means that upward pressure on this category will be severe.

The Fed’s view of these cross-currents will be key to predicting how aggressive policy tightening will remain in the coming months, especially as the central bank begins to shrink its balance sheet.

Potential sales of MBS

The Fed said it would start shrinking its $ 9 trillion balance sheet from June 1, when it will no longer reinvest $ 3 billion in yields on government bonds and up to $ 17.5 billion in mortgage-backed securities per month. These limits are expected to increase to $ 60 billion and $ 35 billion, respectively, in September.

However, some officials have indicated that they will need to be more aggressive in their efforts to partially ease quantitative easing or pandemic bond purchases over the past two years, especially in the housing market. Reducing its $ 3 trillion in MBS holdings will be particularly difficult, as early payments – driven by refinancing activities – will almost stop as rates rise and natural progress is slow.

The minutes of the March Fed meeting showed that officials were discussing the potential need for direct sales of MBS. Citi economists note that recent speeches by the Fed suggest that the topic may not have been “thoroughly discussed” at the last meeting, so any indication to the contrary would be a hawkish surprise.

Write to Lisa Beilfuss at lisa.beilfuss@barrons.com

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