FOMC Preview: Peak Pace Not Peak Terminal

Summary

• The Fed will hike 75bps at the November meeting, but the focus is whether Chair Jerome Powell can convince markets that lowering the pace does not equal dovish.
• The Fed plans to keep hiking until the real funds rate is positive. They will not pause until they have more confidence that core inflation has peaked.
• The December dropdown to 50bps makes a lot of sense, but the pause after the end of the year still seems like a stretch to me.

We have come a long way from the September FOMC and Jackson Hole. Following these two episodes, markets panicked. The thought was that a deceleration in rate hikes was still distant, and an imagined pause in the rate hiking cycle amid the current nominal GDP backdrop was almost unimaginable.

And despite minimal evidence that the spot inflation data is cooperating, the market narrative has shifted dramatically to a deceleration in hiking in December that Powell will likely confirm at his press conference.

I see two questions going into the FOMC this week. First, what has changed since the last time the committee met? Second, where are they going, as surely the Fed does not want to give the message that ‘dropdown’ equals ‘finished.’

The Fed will hike 75bps at their meeting this week. But the focus is whether Chair Jerome Powell can convince markets that decelerating does not equal dovish.

The September FOMC Was Very Consequential

To me, there were a few key takeaways from the September FOMC and SEP:

1. Immaculate disinflation is dead, at least ex ante.
2. The Mester roadmap: below trend growth to higher U3 to weaker wage growth to lower inflation.
3. It takes two years above NAIRU U3 for inflation to return to target.

Immaculate Disinflation

For much of this year, the Fed has implicitly been running some form of ‘transitory’ narrative. They forecasted inflation to fall back to target without much labour market pain. Even as recently as the June SEP, they assumed that the unemployment rate rising to 4.1% in 2024 would see inflation fall back to target at the end of their forecast horizon.

The Fed no longer thinks this, and this was clear in the September SEP; immaculate disinflation is dead. The Fed now thinks the current state of the labour market is inconsistent with 2% inflation. And more importantly, they want markets (FCIs) to understand that.

The Mester Roadmap

The roadmap, which was really laid out at July FOMC, is clearly live. The formula for the Fed is simple. Below trend growth leads to higher U3, then weaker wage growth, then lower inflation. This is what Loretta Mester laid out at Jackson Hole. The Fed needs Okun’s law to weigh on the labour market and then the labour market to weigh on the wage Phillips curve.

NAIRU U3

It takes two years of U3 at 4.4 for inflation to return to target. I think this is important: this is the Fed’s commitment mechanism to the now often-quoted Volcker line that they ‘will keep at it until the job is done.’ This is the ‘proof’ of the Fed saying they will not blink at the first sign of weakness and that sustained weakness is necessary to get inflation sustainably back to target.

Global Central Bank Dropdown Has Started

Central banks globally have begun to reduce the pace of monetary tightening. This is despite little evidence that much has changed on the spot inflation front and the materially more hawkish Fed reaction function introduced at the September FOMC.

To me there have been five key examples of the dropdown in G10 over the past few weeks:

1. The RBA (Australia) hiked 25bps into 50bps priced. And it has continued at a 25bp pace.
2. Norges (Norway) hiked 50bps and said they see a slowdown to 25bps coming.
3. Riksbank (Sweden) hiked massively (100bps) but showed a low terminal rate.
4. SNB (Switzerland) hiked big (75bps) into positive territory but did not really commit to more. It only said further rate increases cannot be ruled out.
5. The BoC (Canada) hiked 50bps into 75bps priced.

The global theme seems to be that central banks are trying to slow the pace of hikes.

Central banks now want to calibrate policy in a way that reflects two things:

1. They think we have hiked a lot.
2. They think we have arrived at growth zero.

Central banks seemingly want to hand off to the real economy. The problem is the real economy has not given them much of anything yet. Growth is slowing. Interest rate sensitive areas have clearly been hit. But most of the weakness in the global economy is still implied (survey). No developed market economy has really seen the labour market dynamics shift, services inflation slow, or had signs that wage growth is slowing.

So, my takeaway from this week is that the pace will slow. But I do not think terminal has fallen. The market so far has traded this as a flattener in the bond market because we discount that ‘less’ equals ‘finished’ and that, in my opinion, will not be true. That is, the market is inferring a lower destination from a slower pace, and I think that is the wrong takeaway.

No Pause Without Core CPI Peak

There is clearly a ‘pivot itch’ in financial markets. And the Fed is likely to retire 75bp hikes and decelerate. However, the Fed will not pause rate hikes at this level of spot inflation, and the last two spot inflation prints have been really bad.

There are a million reasons for why inflation should drop, and everyone knows them:

• The gap between Manheim/CPI used cars.
• OER is lagged to market rents.
• Apparel prices are disconnected from corporate commentary.
• Supply chain pass throughs should kick in, etc.

But the number does not go down. And to me, it is not about what inflation will print in May of 2023, as I generally agree it will be much lower. However, given the size of the number in both YoY and MoM terms, it does not matter. Not only does the Fed not know if inflation is on a track back to 2%, but the Fed is not convinced that core inflation has peaked, and that is a more fundamental problem for them.

Waller:‘Until that progress is both meaningful and persistent, I support continued rate increases, along with ongoing reductions in the Fed’s balance sheet, to help restrain aggregate demand.’

Kashkari: ‘I’d be fine pausing once I’m confident inflation has peaked.’

Overall

To me, the Fed’s direction is a lot less murky than people think. They will go until the real funds rate is positive and then pause there. That is the plan. And they are not going to pause until they have more confidence that core inflation has peaked.

Now, the Fed also knows this is not the same as the June fight of inflation expectations so there is very little risk of an acceleration. I think the December dropdown to 50bps makes a lot of sense, but the post-end-of-year pause still seems like a stretch to me. The Fed is still operating in a Phillips curve/robust control policy approach, which, at new highs in core CPI, still favours them doing more rather than less.

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.)