FOMC Review: Fed Won’t Wait for Lagged Policy Effects to Play Out

Summary

• The Fed hiked 75bp, as expected.
• However, the Fed was more hawkish than I expected, with the Summary of Economic Projections (SEP) showing an additional 125bp hikes by end-2022, against the 100bp I was expecting.
• Together with Chair Powell’s presser, this suggests the Fed won’t slow to assess the impact of its hiking until there is actual and compelling evidence that growth and inflation are headed down.
• Based on my view on inflation dynamics and weak transmission of policy tightening to the economy, this could see the FFR close to 8% by mid-2023.

Market Implications

• The market is underestimating the amount of Fed tightening in 2022 and 2023.
• Negative equities, further 2s10s curve inversion.

Looser Guidance

As consensus and I expected, the Fed hiked the Federal Fund band 75bp to 3- 3.25%.   The statement was identical to July’s except for an upgrade of the assessment of spending and production, from ‘have softened’ in July to ‘modest growth’.

The dot plot survived! And it showed another 125bp increase in the end-2022 FFR against my expectations of 100bp (Chart 1). The terminal rate was lifted to 4.6%, roughly in line with my expectations. 

The SEP continued to show a soft landing scenario, in line with my expectations.   Unemployment peaks at 4.4% in 2023-24 and falls to 4.3% in 2025.  Inflation falls smoothly back to target in 2025. Growth slows to 0.2% YoY in 2022 and rises thereafter to 1.8%, its LT trend, in 2025.

Fed Won’t Slow Until Actual Growth and Inflation Have Slowed

The Fed has now hiked 225bp in 6 months. This is the fastest pace of increase since they started targeting the FFR in 1982 (Chart 2).

Due to Fed communications, since the July meeting, highlighting that ‘at some point it will become appropriate to slow the pace of increases, while we assess how our cumulative policy adjustments are affecting the economy and inflation’, I was expecting the Fed to slow to a 50bp hike /meeting clip over the remainder of 2022.  This would allow the variable lags in monetary policy transmission to play out and lower the risks of over tightening.

The dot plot shows that I was wrong. When then, is the Fed likely to slow?

Chair Powell was asked this question repeatedly during the presser.  His answers were:

• When we have compelling evidence that inflation is returning to 2%.
• When it is clear that growth has slowed below trend and labor market conditions have softened.
• When the real FFR is positive, based on forward looking expectations.
• When financial conditions are tight enough to slow growth.

These answers make clear that the Fed will not slow when it expects to have done enough to bring inflation back to target. Rather the Fed will slow the pace of rate hikes when it sees actual inflation and growth slow in a convincing manner.  A convincing manner likely means a string of consecutive data showing inflation and growth are headed down.

Fed to Hike 75bp/Meeting Until Mid-2023

Powell further indicated that ‘we have just moved into the very lowest of what might be restrictive’. He further indicated that he wanted the real FFR to turn positive, though this was based on ‘forward looking’ inflation expectations, which gives him a lot of leeway considering how many ways such data can be estimated.  Nevertheless, the message is clear: Chair Powell is prepared to go much higher.

This suggests the Fed could hike at a 75bp/meeting clip at least until mid-2023 (i.e. the FFR could be close to 8% around mid-2023) for 2 reasons.

First, the economy still has a lot of momentum (please see Q2 GDP: Growth to Turn Positive in H2). 

Second, because of more than a decade of very low rates, the real economy has become much less sensitive to financial conditions. Fed policy tightening is likely to have much less of an impact on the real economy than consensus assumes.

As a result, even if the Fed manages to tighten financial conditions, employment growth and inflation are unlikely to slow much.  I intend to develop these themes in future research.

This is a different FFR scenario from my previous expectations that the Fed would slow its hikes, realize in early 2023 that inflation and growth were not slowing, and announce a major increase in the terminal rate in March 2023.

Market Consequences

Markets are underpricing Fed hikes in 2022-23.  In addition, my FFR views imply further downside for equities as well as a much deeper curve inversion than currently 55bps (2s10s).

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.)