Fed To Slow Tightening Pace After Weak GDP? It Is A Naive Fantasy

August 1, 2022

| Fullerton Markets

Fed To Slow Tightening Pace After Weak GDP? It Is A Naive Fantasy">

The dollar dropped, stocks rallied, and US bond yield fell. That was the market reaction we saw last week. The question is will these price reactions be sustainable?

We doubt so. All these moves were driven by the expectations that the Fed is going to moderate the policy tightening. Recent data reflecting slowing growth have led traders to bet the Federal Reserve will pause its rate hikes later this year. However, data this week may show this is the largest market mispricing of what the Fed will do.

Over the past week, the upside surprise to inflation data has been more significant than the downside surprise to growth. At the press conference after July’s FOMC, Fed Chair Jerome Powell said the committee would look through a negative second-quarter GDP print. However, if inflation continues to surprise to the upside, September could see another large rate hike, and it could be another 75bps.

Since then, relevant inflation data have all surprised the upside. Wage growth does not appear to have peaked. The University of Michigan’s final estimate of 5-10 year inflation expectations edged up, contrary to analyst expectations. The PCE deflator was also higher than the consensus.

The second-quarter GDP likely did not contain much information the Fed had not already considered. In our view, the most important signal was that growth momentum has cooled, but we are not in a recession yet. The ISM PMI indexes will likely confirm that economic activity will continue to expand this week.

The labour market will settle the question of whether we are already in a recession. If a recession is not imminent, Fed will prioritise cooling down inflation. More importantly, we think the jobs data this week will tell a story that the US economy still has enough resilience for the Fed to continue raising rates.

The Bank of England this week may remind investors that the war of fighting inflation is far from over. It is expected to deliver another half-point increase in borrowing costs. The move anticipated by most analysts and investors would mark the UK’s biggest increase in interest rates in 27 years and accelerate a historic pivot away from the era of cheap money. Governor Andrew Bailey has suggested the hike would not be the last, saying policymakers are prepared to act “forcefully,” if necessary, to rein in inflation.