FOMC Preview: Pivot Headaches

Summary

• A pivot announcement at the 2 November FOMC meeting is unlikely as it would lead to a marked easing of financial conditions when inflation is high and persistent.
• The economic case against pivoting is strong but unlikely to drive the Fed’s decision.
• Rather, the Fed’s weak inflation framework suggests it will remain reactive to short-term data developments that are likely to support another 75bp hike in December.

Market Implications

• The recent dollar weakness and bond and risk asset rallies could reverse after the November FOMC meeting.

Any Pivot Will Be Tactical 

Markets are pricing a 75bp hike to 3.75-4.00% at the 2 November FOMC meeting. I agree, based on Fed communications (contrary to earlier statements, the Fed was unable let go of forward guidance).

The more open question is that of the ‘pivot’, i.e., of when to let go of the 75bp/meeting increases. A 75bp hike next week will be the fourth such hike in a row and the fastest pace of increase in the fed funds rate (FFR) since the 1970s. A further 75bp hike at the December meeting would bring the FFR to 4.50-4.75%, the terminal rate listed in the September Summary of Economic Projections (SEP).

FOMC members have been debating how long to sustain that pace. The doves want to slow it. For instance, San Francisco Fed President Mary Daly stated on 21 October that ‘it was time to start talking about slowing interest rate hikes’. 

The hawks, for instance, St Louis Fed President James Bullard, favour more frontloading.  Following the higher-than-expected September CPI, Bullard said it was too early to prejudge the December meeting but that, ‘if it was today’, he would go for another 75bp hike.

What hawks and doves agree on, though, is that the pivot would be tactical rather than strategic. That is, the pivot would not open the way to a lower terminal rate. Even Lisa Cook, one of the more dovish Fed governors, believes a pause in tightening would have to be based on an actual rather than expected inflation decline.

And actual inflation currently gives no scope for a lower terminal rate (Chart 1). The pivot discussion is currently tactical, not strategic. The issue is how to implement it.

Pivot Expectations Are Self-Defeating

At the September meeting, 17 of the 19 meeting participants saw inflation risks skewed to the upside. Since then, the data has supported their assessment (September 2022 CPI: Still in Line With Macro Drivers). Therefore, the last thing the FOMC wants now is easing financial conditions.

And pivoting without easing financial conditions will likely be difficult. Following the July FOMC meeting, misperceptions of a pivot led to a marked easing of the Financial Conditions Index (FCI, Chart 2). Similarly, this time, pivot talk has also eased financial conditions. If Chair Jerome Powell mentions a pivot next week, the FCI is set to become much looser.

The Fed therefore needs a pivot strategy that can avoid easing financial conditions. The Wall Street Journal’s Nick Timiraos suggested going for a 50bp hike in December while simultaneously increasing the 2023 dot.

The problem with such an approach is that a tactical slowdown in the pace of hikes would end up lifting the terminal FFR, i.e., tightening policy more than without a pivot.

This inconsistency is another example of the self-defeating nature of the game of mirrors played between the Fed and markets. Former Fed Governor Jeremy Stein (now a Harvard economics professor) presciently wrote in a 2014 speech:

‘There is always a temptation for the central bank to speak in a whisper, because anything that gets said reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified. So efforts to overly manage the market volatility associated with our communications may ultimately be self-defeating.’

In other words, the Fed would be better off focusing on how much more tightening is needed to slow the US economy. That is, instead of worrying about market reactions and associated FCI changes that, in any event, are a poor measure of policy transmission (The Fed is Pumping the Brakes but The US Economy Is Not Slowing).

Strong Economic Case Against the Pivot 

The economic argument for pivoting is that monetary policy impacts the economy with long and variable lags (Table 1;  Chart 3, based on the tightening cycle chronology of Alan Blinder, former Fed vice chair, and on core PCE).

However, a close look at Table 1 and Chart 3 shows transmission lags (measured by the time between first hike and inflation peak) are not directly observable. Rather, estimating them requires econometric models subject to many assumptions. 

The difficulty of measuring policy lags is shown for instance by: 

• The July 1980-May 1981 tightening cycle saw inflation peak in November 1980, but this peak also reflected the impact of the January 1977-June 1980 tightening cycle.
• The March 1988-February 1991 tightening cycle saw two inflation peaks, in February 1989 and in September 1990.
• The tightening cycles starting in February 1993 and December 1993 did not see an acceleration in inflation.

On the other hand, what is unambiguous is that higher inflation at the start of the hiking cycle is associated with a larger increase in the real FFR (Chart 4). The chart also suggests that this time the Fed will have to tighten by much more than forecast in the September SEP.

While the case for a pivot rests on ambiguous data, the economic case against a pivot is straightforward. The Fed is already behind the curve (Chart 5). Resource pressures are exceptional, as shown by exceptionally low unemployment and exceptionally high profit margins (those tend to be positively related to resource pressures). If the Fed slows the pace of hiking, inflation is likely to accelerate and the Fed risks falling further behind the curve.

Pivot Unlikely

All this suggests Chair Powell is unlikely to signal a pivot next week as this could trigger an easing of financial conditions inconsistent with the Fed’s inflation objectives.

Instead, the Fed is likely to remain reactive to short-term data developments, largely because its inflation models are not working. Inflation expectations measured by the Fed’s Index of Common Inflation Expectations remain the highest in the history of the series (Chart 6). Yet the Fed keeps communicating that they are well anchored. And even if inflation expectations are well anchored, actual inflation is accelerating.

Similarly, the Fed considers a 2.5% FFR as neutral even though inflation is currently 6-8% depending on how it is measured. It is hard to see how a FFR rate well above neutral is consistent with current labour market strength.

And there is no sign that the meeting participants are considering a reassessment of their inflation models. The Fed minutes stated that the Fed staff had revised down their estimate of potential output and therefore ‘revised up considerably’ their estimate of the output gap.  This however has not percolated to meeting participants who continue to see long-term growth and unemployment roughly unchanged from before the pandemic.

Absent a model that can make sense of the data, the Fed is likely to continue to stress the ‘exceptional uncertainty’ around the current economic situation and continue to be ‘data driven’. In plain English, this means the Fed will react to the last CPI print. Based on my bullish view on inflation and growth, this suggests another 75bp hike at the December meeting.

The main risk to my view would be systemic bond market instability. However, recent Treasury announcements of possible buybacks suggest these would be handled through direct intervention and/or regulatory relief rather than through slower policy tightening.

Another risk to my view could be if the Fed turns out to be more of an Arthur Burns than a Paul Volker Fed. I see this as unlikely given the political pressures on the Fed to control inflation. These are only likely to strengthen after the Republicans take over Congress in the midterms. 

That said, except Governors Christopher Waller and Michelle Bowman, all the current Governors are Biden administration appointees. So while an Arthur Burns Fed is not likely, it is not impossible either. The pivot or lack of will be a key data point.

Market Consequences

If my view is correct, the recent dollar weaknesses and risk asset and bond rallies are likely to reverse after the FOMC meeting.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(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.)