FOMC Preview: The Last ‘Easy’ Meeting

Summary

• The Fed will likely hike 75bps today and sound like they did at the June FOMC, even though much has changed.
• The market is saying inflation will improve, but the Fed will say the June SEP dots are still right (3.4% by year end) because there is no compelling evidence yet that inflation is falling back to 2%.
• July is the last ‘easy’ meeting for the Fed. Spot inflation is too high, they are nervous about inflation expectations, and policy is not restrictive yet. However, this will likely not be the backdrop at the November FOMC: the Fed will be at restrictive policy levels, and they will have to weigh inflation goals against economic weakness.

Two Dualities

For the FOMC right now, we are in two very interesting dualities:

1. There is a time inconsistency element between the market and Fed reaction functions. The market thinks inflation is about to fall considerably while the Fed has set themselves up to react exclusively to spot month-over-month inflation prints. The Fed is saying look at spot CPI, and the market is saying look at 10y breakevens.
2. The Fed has a clear job to do today. But the ‘goals in conflict’ theme (where the Fed must weigh inflation risk vs unemployment risk) is being pushed forward as the economic slowdown has happened much faster than they thought it would. For today, this theme is not yet relevant. The Fed is still below restrictive, and headline inflation is still accelerating; they told us that until both of those things change, there is nothing to talk about.

Time Inconsistency

There is a chasm between the market and Fed reaction functions. The Fed is looking at inflation at 9.1%. They told us there is no nuance and that headline inflation equals inflation expectations. However, the market is saying inflation has clearly peaked and that, while it is unclear when we get back to 2%, assuming the current path for rates over the next few meetings, the bigger concern is then growth.

• The Fed is saying: Inflation is at 9%, so we will go big.
• The market is saying: In six months, the inflation picture will look nothing like this.

I think this chasm is so much of the story right now and will continue to be today. I think Chair Jerome Powell will say that things have changed little while the market continues to suggest that they have. He will say inflation is at 9%, and the labor market is still tight. The market will say, ‘look at PMIs, initial jobless claims rising and breakeven inflation rates.’ Meanwhile, Powell will sound the same as he did in June: inflation is still the number one goal, and there is no compelling evidence it is falling, even if the bond market currently disagrees.

I also think Powell will sound like he did at Sintra. A theme I think will be relevant at the July FOMC was highlighted at the ECB Sintra conference in June: the Fed is still in a ‘risk management’ phase. That phase is very hawkish, and the calculus is fairly simple.

Inflation Expectations Outweigh Recession Risks

For central bankers right now, the risk of further-rising longer-run inflation expectations is a bigger risk than causing a recession. This came across clearly at Sintra. Powell said that ‘the bigger mistake’ would be not restoring proper price stability, and Christine Lagarde agreed. Even Andrew Bailey at the Bank of England, who is forecasting a recession as a base case in the UK next year, said it is all about second-round effects – if they materialize, nothing else matters.

The kicker for this theme was, it is not safe to assume inflation expectations are anchored.

Powell said that ‘the clock is running’ for inflation expectations and that, while headline CPI is this high, the chances of them de-anchoring rises. That is, Powell is not looking at anchored inflation expectations as a given but something he must protect as a ‘risk management thing.’

This is something that Loretta Mester said in a speech. It is all about expectations to her:

• ‘Work done at the Cleveland Fed and by other researchers finds that including measures of inflation expectations in inflation forecasting models reduces the size of forecast errors.’

• ‘In the current situation, from a risk-management perspective, it is important for policymakers to ask which situation would be more costly: erroneously assuming longer-term inflation expectations are well anchored at the level consistent with price stability when, in fact, they are not?’

The thinking for central banks right now is that a mild recession is better than the current set up of 8-10% headline inflation. And if that is the tradeoff, they will take it. For central banks, the bigger mistake is doing too little rather than too much. At least, that is what they are saying.

That is a tough message to hear when the market is preparing for growth and inflation to begin slowing quite rapidly. With that said, this could be the last ‘easy’ meeting for the FOMC. Things will begin to change in the fall/winter of this year.

Simple Calculus for Central Banks so Far

For central banks in general, the calculus has been simple this year:

1. There is doubt about inflation expectations with unemployment at record lows everywhere. Hike a lot and fast.
2. Headline inflation is 8-10% in DM, and policy rates are still well below neutral. Hike a lot and fast.

It is easy to be ‘reckless’ when this is your backdrop. For the Fed, the cost of doing 75bps June/July is not that big of a deal when inflation is at 40-year highs, the unemployment rate is near 40-year lows, inflation expectations are perhaps bit too high, and the policy rate is 100bps below neutral.

For a central bank, it is a fairly easy job: just get to neutral as fast as possible, and you can be reckless in doing it. The combination of inflation expectations and well-below-neutral policy rates created a massive tail to paying fixed income. But it is changing. The Fed may not sound the same at 3.5% on the funds rate as they do now with the funds rate at 1.58%. The Fed will be 100bps restrictive v 100bps easy; it is a different game. The Fed and most central banks have had a cheap option in getting inflation lower because there was so little slack globally.

As the Fed gets to neutral this week and restrictive in September, the tradeoffs will begin to get harder as the economic slowdown gathers pace.

Overall

The Fed will hike 75bps today and sound like they did at the June FOMC even though much has changed. Today’s FOMC is indicative of two dualities: the gap between the market/FOMC reaction functions and the looming “goals in conflict” theme the Fed must soon address. The market is saying that inflation will improve, but the Fed will go 75bps and say the June SEP dots are still right (3.4% by year end) because there is no compelling evidence, yet, that inflation is falling back to 2%.

We are in this time inconsistency state where the Fed is reacting to June CPI and the market is trading the European recession. The Fed will side with June CPI, and I think to more of a degree than risk assets are suggesting right now.

The Fed said that until there is compelling evidence that inflation is beginning to fall and that they are at a restrictive policy setting, there is nothing to talk about. So that does not change anything for today, and it will be a very hawkish message.

However, going into Q4, things will begin to change for the Fed. Therefore, I think July is the last ‘easy’ meeting for the Fed. Spot inflation is too high, they are nervous about inflation expectations, and policy is not restrictive yet. However, this will likely not be the backdrop at the November FOMC. The Fed will be at restrictive policy levels, and they will have to begin to weigh inflation goals vs economic weakness, especially in the context of falling inflation.

For the Fed right now, it is 9.1% inflation, 3.6% unemployment and a policy stance that is not restrictive yet. That will shape the July FOMC message, but this will not be the backdrop three months from now.

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.)