FOMC Preview: From a Rush to a Grind

Summary

• The economy is much stronger than the Fed thought at the July FOMC, and the September FOMC will reflect that in both tone and action.
• The hiking cycle is transitioning from a rush to a grind: expect a 75bp hike today and the dots to show 4% by end 2022 and 4.5% by end 2023.
• The Fed will follow the ‘Mester Roadmap’: two years (2022-23) of below-potential growth, which will equal unemployment up to a 4% handle by end 2023 and inflation back to 2% target by end 2024.

At a Transition Point

The Fed meets today to set interest rates. A theme I have been discussing over the past few weeks is the potential for the Fed to transition from a ‘rush’ to more of a ‘grind’. The recent core CPI print has delayed that theme, but I consider it still relevant for thinking about Fed policy into 2023.

I originally thought we might see the Fed start decreasing the size of rate hikes today, and I was wrong about that. But I continue to think we are at a transition point for Fed policy where it is more about the destination than the pace. As such, I now cover three questions:

1. Where are we?
2. Where are we (really the Fed) going?
3. Summing those, what will the September FOMC sound like from dots to presser?

Where Are We?

Much has changed since the Fed last met in July.

First, European yields have exploded higher since August on the prospect of continued FX weakness, higher inflation and more fiscal spending to combat the current pressures on household balance sheets. The massive move in UK Gilts and German Bunds have spilled over to US treasury yields and contributed to the rising yield environment of the last six weeks.

Second, the US economy has shown much resilience to events in the global economy and the rising interest rate environment. Jobless claims have come back down, the economy is still producing a lot of job growth, consumer sentiment has risen a bit on the back of falling gas prices, and consumption is still quite strong.

There is little the Fed can do about the first thing, but the second thing I expect to be a theme of the September meeting. The Fed had the economy wrong at the July FOMC; the statement and minutes evidenced that. This was the first sentence of the July statement: ‘recent indicators of spending and production have softened’.

Between Chair Powell’s presser and the minutes, the Fed clearly bought the recession chatter over the summer. This is important as I think something that underpinned the more ‘dovish’ July meeting was assumptions on growth that may not actually be sticky, especially considering recent data. The Fed sat down at July FOMC and said, FCIs are really tight, the economy is slowing quickly, and it is only a matter of time until the unemployment rate is rising. The Fed was ipso facto trying to lean into the ‘hawkish handoff’,where you no longer need to add incremental rate hikes to the ED strip because the economy and FCIs turn into the heavy lifters for lowering inflation. And this is exactly what we saw in the Fed minutes:

‘Participants noted that a period of below-trend GDP growth would help reduce inflationary pressures and set the stage for the sustained achievement of the Committee’s objectives of maximum employment and price stability.

They judged that this behavior of longer-term inflation expectations was likely partly due to the actual and expected firming of monetary policy and also likely reflected downward revisions to the growth of aggregate demand expected in coming years.’

Eight weeks ago, the Fed thought that FCIs were tight, the economy was slowing quickly, and it was a matter of months until we saw a negative payroll print. Today, they are not confident the economy is slowing enough to dent core inflationary pressures. The Fed said they needed below trend growth to help them achieve their dual mandate goals, and the slowdown they thought they saw in July was part of that. Looking at the recent labour market and consumption data, they clearly have a lot more work to do to achieve that desired goal. The economy is much stronger than they thought at the July FOMC, and the September FOMC will reflect that in both tone and action.

Where Are They Going?

In terms of next steps, I think the cycle is transitioning from a rush to more of a grind. The question now is more about persistence than pace.

The Fed is entering a transition phase:

• The first phase was rising inflation, a way-offside policy stance and worrisome inflation expectations. That catch-up was accelerated via FCI assistance.
• The next phase is sticky inflation and trying to prevent markets from undoing the Fed’s hard work.

The pivot point from September will be the handoff from risk management back to a traditional Phillips curve framework. The Fed is becoming more confident that inflation expectations are well anchored; gas prices are not $5 a gallon anymore, the supply side is healing, and headline inflation is not running away from them.

The Fed’s problem is that wage growth is over 5%, the labour market is still very tight, rents are still rising, core services are strong, and stickier measures of inflation continue to accelerate. As we saw last week, the Cleveland Fed trimmed mean CPI measure hit a new high.

However, considering last week’s inflation print and now the September meeting, the Fed is in a very different place to where they were in June, in terms of a ‘Timiraos leak’. The inflation expectations fight and the core services one are different. Fed could/did get gas prices lower to anchor expectations via FCIs in June. Hiking 100bps will not help OER print 0.3% next month.

And that is what the Fed will begin focusing on now. They will focus less on inflation expectations and more on the level of the funds rate that equilibrates supply and demand across the whole economy in a way that is consistent with their 2% inflation target. Fed policy is returning to its roots: the Phillips curve.

The Fed does not need to shock the market to get oil prices to reduce gas prices, which lowers inflation expectations. The next stage of this fight is much more traditional: get the economy to operate below trend to return inflation to target. I think this is where the balance of the committee is; even Brainard referenced it in her speech. But I call it the ‘Mester roadmap.’

The Mester roadmap for getting inflation back to target is something like this:

Have two years (2022-23) of below-potential growth, which will equal unemployment up to 4% handle by end 2023 and inflation back to 2% target by end 2024.

So What Will the September Meeting Look Like?

I think the focus of the meeting will be on two things: what do the dots look like, and how does Powell sound? And between these two marginal factors, there is an overarching theme: the July FOMC was wrong. First, the Fed had the weakness the economy went through at the end of Q2 wrong in terms of its magnitude. Second, the idea of an immaculate disinflation is now fading.

Let us start with the dots. In terms of the 2022 and 2023 median fed funds estimate, these will be revised up higher from 3.4 and 3.8 to show the funds rate at 4% by the end of this year and 4.5% by the end of next, much more in line with market pricing. The outer years, with the first 2025 dot being shown, will likely show some cuts but not back at neutral. This will be a way to show commitment to ensuring inflation settles back at 2%.

With the economic forecasts, the big thing to watch is the unemployment forecast for next year and 2024, which I think must show slack building. Led by Waller and Mester, the Fed is starting to think inflation in the context of the current labour market cannot return to 2%. It previously thought only a slight rise in the unemployment rate need happen and that inflation would fall back to 2% over the course of the forecast horizon. This is now changing. The Fed is saying they need economic slack to develop for inflation to return to target, and that means their unemployment forecast must rise.

Overall, the theme for today to me is not about 75 or 100bp, though I am in the 75bp camp. It is that the Fed thought the economic weakness of Q2 would help them return inflation to target, and they no longer have that confidence. The story of the data from the July FOMC through August CPI last week was that this excess demand is proving sticky. And while the Fed solved for gas prices, the battle now is core services, the fighting of which will require labour market pain.

Powell will likely echo Jackson Hole today, saying the economy must suffer some pain. But the bigger thing to watch for is where Powell thinks we are along that journey – the risk is he now thinks we have barely begun.

Jon Turek is author of the Cheap Convexity blog and CEO of JST Advisors.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)