Key takeaways
As expected, the Fed left the target range unchanged at 2.25-2.50% and overall there were no major changes to the policy signals (Powell said the IOER rate cut was a technical adjustment and not an expression of an easing bias, see more below). On one hand, the Fed said economic growth and the labour market remain strong but on the other hand, inflation is running below the 2% target
The Fed caught market by surprise by cutting the Interest on Excess Reserves (IOER) by 5bp to 2.35% from 2.45% but Powell stressed during the press conference that this should not be interpreted as the beginning of an easing cycle. The Effective Fed Funds rate (EFFR) has risen to 2.45% since Easter due to a decline in the supply of bank reserves and was thus only 5bp below the top end of the Fed's target range. The quickest way for the Fed to return the EFFR closer to the mid-point is to cut the IOER. There had been speculation in the market that the Fed could make this move at the June meeting, but the market was not priced for a cut to come at the May meeting - the May Fed Funds futures have traded around 2.42%.
The Fed made two similar adjustments last year and could be forced to make one more adjustment later this year, as the supply of bank reserves is set to continue to decline due to the Fed's quantitative tightening, which will go on until the end of September. With the IOER firmly below the Fed's mid-point target for the Fed funds rate now, the Fed has effectively implemented an interest rate corridor system, as seen, e.g., among European central banks. A second step in this transformation could be the introduction of a new repo facility. Powell mentioned that the Fed is looking at this option and will return to it at an upcoming meeting.
Initially, markets interpreted the IOER rate cut as a dovish twist but US yields ended higher and the USD stronger after Powell's comment that the Fed is firmly on hold and not about to cut rates near term. We maintain our view that the Fed is on hold for the rest of this year and next.
