Monetary Policy & Inflation | US
FOMC Review: Fed Remains Behind the Curve
- By Dominique Dwor-Frecaut
- 5 min read
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Summary
- The Fed hiked the FFR 75bp as expected.
- The SEP still shows the Fed still expects most disinflation to come from factors outside monetary policy.
- Short-term inflation prints are now driving Fed policy.
- Therefore, a switch to a more proactive policy will require overwhelming evidence that the current policy is failing, which will likely be unavailable until 2023.
- Meanwhile the Fed is likely to follow the markets. Based on my inflation and growth view, my base case scenario is for the markets to guide the Fed to an end-2022 FFR of about 3.8%.
Market Implications
- Bonds and stocks to sell off (Themes and Trades Ideas has full discussions).
The Fed Still Believes in Immaculate Disinflation
As expected, the Fed hiked the Fed Funds rate (FFR) 75bp. And in line with market pricing and my expectations, the Summary of Economic Projections (SEP) showed the end-2022 FFR at 3.4%.
But overall, the SEP was less hawkish than I expected. It showed the FFR increasing to 3.8% in 2023 and cut to 3.4% in 2024, against my expectations of 4.5% in 2023-24. Also, unemployment only increased in 2024 by 10bp above long-term employment, which remained at 4%.
I think the SEP is unrealistic for two key reasons. First, the SEP shows the gap between the FFR and Taylor rule falling during 2022-24, which aligns with past tightening cycles. However, the decline in the gap reflects mainly a decline in the SEP implied Taylor rule FFR (Table 1).
By contrast, in every tightening cycle since WWII, the Taylor rule FFR has increased during the tightening cycle (Immaculate Disinflation Risks a Protracted Recession). This reflects that tightening cycles are typically triggered by macroeconomic imbalances that take time to resolve. That is, the June SEP still relies on immaculate disinflation, i.e., disinflation caused by factors unrelated to Fed policies.
Second, the SEP shows almost no increase in unemployment. Yet such an increase is likely necessary to lower wage growth and inflation (End 2022-PCE to Exceed Fed Forecast). With high inflation and very low unemployment, a feedback loop already exists between wages and inflation (Chart 1).
The relationship between employment composition and wage growth has shifted out since April 2021, doubtless due to higher inflation. This is also consistent with the generalization of inflation pressures. This price-wage feedback loop is giving inflation persistence. Breaking it will require a much bigger increase in unemployment than the SEP showed, i.e., a hard landing.
Also, Chair Jerome Powell downplayed the recent increase in inflation expectations. He stressed the Fed was concerned, but he did not admit expectations were de-anchoring (Chart 2). He was asked, ‘in the inflation-expectations data, was there something you saw that was unsettling enough to risk eroding the credibility of your verbal guidance?’ Powell answered: ‘expectations are still in the place, very much in the place, where short-term inflation is going to be high but comes down sharply over the next couple of years.’
Furthermore, Powell did not explain how inflation expectations would drop. He stated, ‘headline inflation is important for expectations’ and ‘expectations are very much at risk due to high headline inflation.’ But, he admitted, ‘we can’t really have much of an effect (on headline inflation)’.
I am not a fan of inflation expectations. But the statements suggest the Fed lacks a clear strategy to deal with what, by its own standards, is a key risk to its inflation outlook.