FOMC Preview: Treading a Fine Line Between Optionality and Credibility

Summary

• A 75bp hike is likely at the FOMC meeting next week.
• Chair Powell is likely to push back against market pricing of cuts in 2023, likely with limited success because strong hawkishness could further undermine the credibility of the Fed forward guidance.
• Powell will likely hint at next QT steps; I expect the bond cap to be lifted to $90bn in December and outright MBS sales to start in Q4.

Market Implications

• Limited impact: 75bp is priced in, and I do not expect Powell to convince markets that the Fed will not cut in 2023.

Fed to Hike 75bp

The Fed likes to announce policy changes ahead of actual policy meetings. When market expectations are misaligned with Fed intentions, the latter tends to provide hints to a few trusted reporters (as always, I am not judging Fed policies just trying to anticipate them). Since we have not heard from these reporters, we can safely assume the Fed will hike 75bp, as implied by the very public debate among FOMC members ahead of the pre-meeting blackout.

Fed to Tread Fine Line Between Guidance and Policy Optionality

The Fed is likely happy with current market pricing of 2022 hikes. Based on FFR futures, the market expects the end-2022 FFR at 3.5%, near the 3.4% in the June SEP (Chart 1). That is, past July, the market sees only about 115bp in additional hikes.

Market pricing is consistent with the Fed stressing it was frontloading hikes rather than raising the FFR trajectory. Also, after next week’s 75bp hike, the FFR will be near the level the Fed thinks is neutral (2.5%). These imply that from July onwards, hiking should slow, as priced by the market.

That said, Chair Jerome Powell probably knows the risks of repeating the sequence seen since the March meeting:

1. The Fed announces a forthcoming meeting hike.
2. Inflation data prints worse than expected.
3. Markets reprice the meeting.
4. The Fed breaks forward guidance and follows the market.

So Powell is likely to tread a fine line between validating current Fed forward guidance, basically the June SEP, and keeping policy optionality. In the process, he may hint whether the terminal FFR will be lifted in the September SEP (my expectation).

Fed to Push Back Against Expectations of 2023 Cuts

I expect Powell to push back against market pricing of the 2023 meetings. The market sees the FFR peaking between the December 2022 and February 2023 meetings and is pricing nearly a full cut by the June meeting. By end-2023, the market sees the FFR back at 3%, contrasting the June SEP, which shows the FFR rising to 3.8%.

Powell will likely push back for three reasons. First, market pricing is inconsistent with the Fed narrative of soft landing as a base case.  Second, Powell probably knows inflation may not slow as easily as the June SEP envisioned. 

Third, the Fed moves in economic not market time, with the former much slower than the latter. Policy changes require an accumulation of evidence that typically builds over several months. And given the Fed’s recent inflation-forecasting record, it would likely require compelling evidence to lower its FFR trajectory

I do not expect Powell to convince markets to take out the 2023 cuts. This could require more hawkishness on his part than would be consistent with the FFR nearing ‘neutral’.

Hints of QT Updates Likely

The Fed’s current guidance on QT covers only the June-November period. I expect Powell next week to hint at what comes next. I expect the reinvestment caps for bonds to be increased to $90bn a month from December, compared with $60bn a month up to November. 

I also expect the Fed to proceed with outright sales of MBS in Q4, possibly starting with $35bn a month. Please see full discussion in QT2: Beware of Regime Change.

Market Consequences

I expect this meeting to have limited market impact since 75bp is already priced in, and Powell is unlikely to convince markets the Fed will hike further in 2023.

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.)