MFN - How hawkish is the Fed?

The latest Federal Open Market Committee (FOMC) minutes provide a window into the Fed’s thinking at its February meeting. In this Macro Flash Note, Sam Jochim examines the implied policy bias of the Fed with the help of EFGAM’s Fed Hawkishness Indicator.

The EFGAM Fed Hawkishness Indicator (FHI) aims to track the policy mood inherent in the FOMC meetings (see Chart 1). It does so by counting the number of times key terms such as “elevated”, “robust”, “high”, and “strong” are repeated in FOMC meeting minutes. The output simply represents the number of times each key term appears.

Source: Fed, Refinitiv and EFGAM calculations. Data as at 23 February 2023.

A notable characteristic of the indicator is its volatility. While large meeting-to-meeting moves may reflect a rapidly changing economic environment, they also imply a level of caution is needed when interpreting the indicator. Looking past short-term volatility to longer term trends is more informative.

One of these trends is the correlation between the FHI and the core personal consumption expenditure (PCE) price index. From January 2010 to December 2022, the FHI has a correlation with year-on-year core PCE inflation of 72%. Unsurprisingly, the recent downward trend in core PCE inflation was associated with a reduction in the FHI.

The relationship between the FHI and the Fed funds rate is also notable. The FHI rose rapidly before the Fed funds rate was increased in March 2022. The FHI appears to have peaked in July 2022, when the FOMC voted to increase interest rates by 75 basis points for a second time. As the FHI declined, the Fed continued to hike by 75 basis points at each of the two following meetings, before slowing the pace of rate increases to 50 basis points in December and 25 basis points in February. It appears that in the most recent monetary policy cycle, the evolution in the tone of the FOMC has signalled changes in the size of interest rate increases.

Despite the recent easing of the FHI, the indicator remains elevated, and its decline should not be overstated. The minutes of the February FOMC meeting highlighted that the Fed is attentive to inflation risks, and cautious not to under-tighten or stop before inflation is sustainably returning towards its 2% target.¹ Communicating this effectively is further incentivised by the desire to anchor long-term inflation expectations.

Market expectations based on Fed funds futures on 22 February pointed to uncertainty regarding whether the Fed would hike by 25 or 50 basis points at its next meeting (see Chart 2). Furthermore, expectations for the Fed funds rate at the end of 2023 have increased significantly. The upward shift in expectations relative to 2 February reflects recent stronger-than-expected data, with the labour market notably continuing to remain tight.

Source: Refinitiv and EFGAM calculations. Data as at 23 February 2023.

Despite this, the FOMC minutes pointed clearly to continued tightening at a pace of 25 basis points. The bar will be high for the Fed to raise rates by 50 basis points again as it would indicate a material deterioration in the inflation outlook.

To conclude, the hawkishness of the FOMC remains elevated, although it has recently eased. Markets are uncertain about the size of the Fed funds increase at the March meeting, with a 20% probability attached to a 50 basis point move. The minutes of the February FOMC meeting, as captured by the FHI, point to continued rate increases of 25 basis points until the Fed sees sufficient evidence that inflation is sustainably headed towards the 2% target.

¹ https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20230201.pdf

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