Why the FED Could Hike 50 bps Instead of 25 bps on February 1st 2023

The Federal Reserve will announce their interest rate decision next Wednesday, February 1st 2023.

The markets and analysts are expecting a 25 basis points (bps) rate hike, after some dovishness shown by FED officials. There seems to be a willingness to wait and see the delayed effects of monetary policy.

Here, I'll challenge the status quo and briefly go through two factors that might bring a surprise next Wednesday.

This is just an exercise, and does not constitute investment advice.

The two factors are:

• The financial conditions have been easing over the past three months
• The broad US dollar index has been decreasing since October 2022

 

Factor 1:

Financial Conditions

The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.

Because U.S. economic and financial conditions tend to be highly correlated, the FED also presents an alternative index, the adjusted NFCI (ANFCI). This index isolates a component of financial conditions uncorrelated with economic conditions. This provides an update on financial conditions relative to current economic conditions.

The NFCI and ANFCI are each constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1971. Positive values of the NFCI have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions. Similarly, positive values of the ANFCI have been historically associated with financial conditions that are tighter than what would be typically suggested by prevailing macroeconomic conditions, while negative values have been historically associated with the opposite.  

 

 

 

 

Source:

https://www.chicagofed.org/research/data/nfci/current-data

As seen above, the financial conditions are looser than average, which are associated with increasing credit, leverage, risk and stock market valuations. This set of conditions increases money velocity and might not be suited for the fight against high inflation - the fight that the FED wants to win.

Factor 2:

The US Dollar Strength

The Federal Reserve dollar indexes are designed to help estimate the overall effects of U.S. dollar exchange rate on U.S. international trade.

There are three indexes: the broad dollar index, which is constructed using the currencies of the most important U.S. trading partners by volume of bilateral trade, and two sub-indexes, which split the currencies in the broad index into advanced foreign economies (AFE) and emerging market economies (EME).

The broad dollar index contains the currencies of 26 economies for which bilateral trade with the United States accounts for at least 0.5 percent of total U.S. bilateral trade. These economies are listed below.

 

List of currencies in the broad dollar index:

 

Long-term chart:

 

2020-2023:

Sources:

https://fred.stlouisfed.org/series/TWEXBGSMTH

https://www.federalreserve.gov/econres/notes/feds-notes/revisions-to-the-federal-reserve-dollar-indexes-20190115.html

 

Because the FED is still in the middle of the battle against inflation, if the dollar strength falls too much and too soon, the importing costs will rise, fueling inflation.

Conclusion

 

Jerome Powell has tried to keep the narrative of fighting inflation and said that the FED might have to apply unpopular policies. However, the markets don't seem scared of Jerome Powell anymore.

The easing of financial conditions and the falling dollar strength may be threats to the FED in the fight against inflation. Thus, 25 or 50 basis points are possible next Wednesday.

 

Overtightening is a risk, but it's a risk the FED is willing to take. In reality, the fast rate hikes over the past quarters may already constitute an overtightening. If sustained for a prolonged period of time, demand destruction by bankruptcies and unemployment will eventually come.

Have a nice week.