MNI FED WATCH: Hawkish Skip For June, But Peak Rates Higher

The Federal Reserve is widely expected to leave official borrowing costs unchanged Wednesday for the first time since the pandemic hiking cycle, holding them at 5%-5.25% even as officials are likely to raise their estimates for peak rates in the face of stubbornly high inflation and a very strong labor market.

"Skipping a rate hike," as Fed vice chair nominee Philip Jefferson put it just before the FOMC headed into communications blackout, gives more time to judge effects of 10 consecutive hikes totaling 500 bps over the past year and the aftershocks of bank failures on credit availability.

Continued strong readings on inflation and the labor market are likely to convince a number of officials that more tightening is eventually needed to slow the economy. The May CPI report out Tuesday was largely in line with market expectations, but core prices have now risen 0.4% or more every month for six straight months. Underlying inflation as measured by Fed's preferred PCE price index remains in a 4%-5% range.

With the FOMC at its most divided since the start of the hiking cycle, Fed Chair Jerome Powell is likely to say as little as possible about the outlook for rates. He's expected to leave the door open to a quarter-point move in July but avoid committing the FOMC to any specific future moves.

LAGS AND CREDIT

The post-meeting statement will continue to emphasize "the lags with which monetary policy affects economic activity and inflation." Leading indicators like credit surveys and PMIs are already signaling a slowdown, and some officials worry much of the impact of the Fed's aggressive monetary tightening may have yet to be felt.

Still, others including Fed Governor Chris Waller argue that factors like a more transparent central bank may have altered the U.S. economy's sensitivity to interest rate changes over the years. The level of excess savings coming out of the pandemic that's fueled household consumption and contributed to high inflation is also unique to this cycle, and there is disagreement as to how much of that impetus might still be powering household budgets.

Meanwhile, regional bank failures earlier this year appear to have had a lesser impact on the availability of credit than initially thought. Growth in all types of loans -- residential, commercial real estate, credit cards and auto -- has been flat outside of a two-week period in March. Credit issuances outside of banks have been weaker on a year-to-date basis compared to the 10-year average, but spreads haven't shifted significantly.

Recent research from the Kansas City Fed argues the regional bank crisis will put a smaller dent in inflation than traditional monetary tightening, citing historic evidence suggesting financial shocks generate only modest disinflationary effects.

QT

No change is expected to the Fed's QT program, but some analysts worry massive new borrowing from the U.S. Treasury after Washington's debt ceiling resolution will cause a sharp drawdown of bank reserves. That could force a premature end to QT as soon as the third quarter, one former New York Fed staffer told MNI.

Ex-New York Fed research director James McAndrews also urged the Fed to cap the growth of its overnight reverse repo facility, to forestall the possibility of a run out of banks and into the ON RRP in future episodes of bank stress.