Fed Minutes Reveal More Hawkish Plans to Combat Inflation

Key Takeaways:

• The minutes from the Federal Open Market Committee’s (FOMC) March 15-16 meeting showed that many officials would have preferred a 50-basis point increase to the federal funds rate but ultimately judged a 25-basis point hike more appropriate given heightened uncertainty involving the Russian invasion of Ukraine. Still, many participants noted that one or more 50-basis point increases may be appropriate at future meetings if inflation remained well above the committee’s target. On the topic of balance sheet runoff, “participants generally agreed that monthly caps of about $60 billion for Treasury securities and about $35 billion for agency MBS would likely be appropriate,” phased in over a three-month period.
• The ISM Manufacturing Index declined 1.5 points to 57.1 in March, its lowest level since September 2020. Any reading above 50 indicates an expansion. The headline decline was driven by a 7.9-point drop in the new orders index to 53.8 and a 4.0-point fall in the production index to 54.5. The employment index increased 3.4 points to 56.3, its highest level since March 2021. The prices paid index jumped 11.5 points to 87.1, its highest level since June 2021.
• The ISM Services Index rose 1.8 points to 58.3 in March, the first increase in four months. The new orders index increased 4.0 points to 60.1 and the employment index moved back above the expansionary threshold of 50, rising 5.5 points to 54.0. The prices paid index was up 0.7 points to 83.8, just one-tenth below its record set in December 2021 and its sixth consecutive month above 80.
• Factory orders fell 0.5 percent in February, the first monthly decline since April 2021, according to the Census Bureau. However, excluding transportation equipment, which fell 5.3 percent, new orders were up 0.4 percent, while nondurable goods orders increased 1.2 percent. Shipments increased 0.6 percent and unfilled orders rose 0.4 percent.
• Light vehicle sales declined 4.6 percent in March to a seasonally adjusted annualized rate of 13.6 million, according to Autodata. The sales rate is about 21 percent lower than the level in March 2019.
• Consumer (non-mortgage) credit outstanding increased by $41.8 billion in February, according to the Federal Reserve Board. Revolving credit (largely credit cards) increased by $18.0 billion to the highest level in two years. Non-revolving credit (largely auto and student loans) increased by $23.8 billion.
• The real goods U.S. trade deficit narrowed by $1.6 billion in February, according to the Census Bureau. Real exports declined 0.8 percent, while real imports were down 1.0 percent.

Forecast Impact:

The minutes from the March FOMC meeting were noticeably more hawkish than previous communications. If not for the Russian invasion of Ukraine, we believe a 50-basis point hike in the federal funds rate was likely in March and, according to the minutes, there is support among FOMC participants for one or more 50-basis point hikes in the future. A 50-basis point hike in May is in line with the market’s expectations, and we see it as increasingly likely as well. Further, the balance sheet runoff could begin as early as next month. However, given that the recent jump in mortgage rates will lead to a lower rate of prepayment, we believe the Fed is unlikely to be able to consistently hit their $35 billion per month cap on MBS maturing, raising the possibility for outright sales of agency MBS. Though the precise impact of quantitative tightening on long-term rates is difficult to predict, if the Fed begins actively selling off MBS, the spread between the 30-year mortgage rate and 10-year treasury (primary-secondary spread) would likely remain wide or widen further to attract more private investors (the spread began the month around 130 basis points, above the historical average). Therefore, we expect mortgage rates will remain elevated in 2022, which will likely weigh on our outlook of purchase activity as affordability continues to worsen.

The ISM indices remained in expansion territory and are supportive of solid near-term business investment of around 8 percent annualized in Q1, in line with our current forecast. However, the manufacturing prices paid index jumped, reflecting a surge in commodity prices as a result of the Russian invasion in Ukraine, supportive of our forecast of a surge in near-term inflation. Further, the auto industry continues to struggle to match their pre-pandemic sales level given continued production disruptions. We had previously forecast new car prices to begin to modestly decline by the end of the year as supply caught up with pent-up demand, though this outlook may need to be pushed back further given the disappointing early sales numbers. Higher prices are also weighing on consumers’ balance sheets, as consumer credit outstanding jumped above consensus expectations. In the near term, consumers are unable to meaningfully cut back on food and energy consumption, forcing them to dip into savings or utilize credit. While household balance sheets currently remain strong, higher prices will increasingly weigh on real consumption growth.

Nathaniel Drake
Economic and Strategic Research Group
April 8, 2022

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