Monetary Policy & Inflation | US
FOMC Preview: Fed to Follow Market
- By Dominique Dwor-Frecaut
- 3 min read
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Summary
- The Fed will be on autopilot this week with a 50bp hike and the start of QT.
- The SEP will probably show somewhat higher inflation and a higher FFR trajectory, with an end-2022 FFR validating current market expectations: i.e., around 3.25%.
Market Implications
- What the market is pricing is unlikely to be enough to cool the US economy, and I therefore see scope for curve steepening.
Fed on Autopilot for Next Two Meetings
The FOMC will be on autopilot at this meeting and the next one. It will hike the FFR by 50bp at each meeting, and QT will start this month with reinvestment caps set at $30bn and $17.5bn for Treasuries and MBS.
The Fed is likely to stick to 50bp in June and July despite soaring inflation for two reasons. First, to change plans would be an implicit acknowledgement that it is so far behind the curve that it must act now. Second, there likely is no consensus for doing so among the Committee.
Paul Krugman made the dovish case: trimmed mean inflation is already near 3%, and there is nothing sacred about a 2% inflation target. This misses the very inflationary macro backdrop, with hyper stimulus and repeated supply shocks (End 2022 PCE to Exceed Fed Forecast). And, of course, American households are experiencing headline, rather than trimmed mean, inflation!
We will not hear directly from the doves (Cook, Kashkari, Evans, Williams). And we will not know if they hold such extreme views. But the dispersion of the 2022 dots will indicate how far the FOMC currently is from reaching a consensus. By historical standards, the dispersion of year-ahead FFR forecasts in the SEP is the widest ever (Chart 1).
Chair Jerome Powell is therefore unlikely to provide specific answers on the FFR trajectory beyond June and July. Nevertheless, the FOMC must still produce a SEP that will indicate where they are at.
SEP to Advance FFR Hikes
The end-2022 FFR will likely validate current market pricing for three reasons.
First, current market pricing of the FFR trajectory is not radically different from the March SEP. After Friday’s higher than expected CPI, 50bp is now priced in at the September meeting. And the end-2022 dot is expected at 3.25%, against a terminal FFR at 2.8% in the March SEP.
Second, the Fed models of inflation have lost their predictive power. Inflation expectations are stable, but inflation is soaring! In this context, market pricing is the main benchmark left to what is basically a rudderless Fed.
Third, showing less tightening than the market when inflation is soaring would further undermine the Fed credibility.
As far as the 2023-24 dots are concerned, I expect them to be near the end-2022 dot. Essentially, at this meeting, the Fed is bringing forward the terminal FFR but not raising the FFR trajectory much.
In addition, I expect the end-2022 core PCE forecast to get lifted somewhat, e.g., by 25bp, to reflect recent price developments. Meanwhile, the end-2023 could remain near 2.6%. More of an increase would further compromise the Fed’s credibility.
Market Consequences
The curve flattened after today’s higher than expected CPI: 2yr yields increased by about 14bp and 10yr yields by about 10bp.
Yet what the market is currently pricing, i.e., an end-2022 FFR at 3.25% and a terminal rate (proxied by the 181m forward OIS swap) around 3.3%, is nowhere near enough to cool the US economy in my view. Therefore, based on my expectations of the FOMC meeting validating market pricing, I see scope for curve steepening.