FOMC Preview: The Fed Has Traded Guidance Credibility for Inflation Credibility

Summary

• The Fed will hike 75bp and guide to 75bp in July as well.
• It will raise the terminal rate for this cycle to 4%.
• Chair Jerome Powell will focus on ‘a landing’, even if it is not a soft one.
• My theme for the dots tomorrow is a 4&4 for 2023: 4% funds rate and +4% unemployment.

A Hectic Entrance

This has likely been the most chaotic market pricing into a Fed hike in two decades. Since the May CPI print, markets have priced more than 75 additional basis points of hikes for this year. And they have taken the terminal rate of this hiking cycle to just over 4%. These are eye-popping moves.

Then there was yesterday. 20 hours before the FOMC meeting an article dropped from Nick Timiraos (the number one Fed reporter): the Fed is considering hiking 75bps. This locked in a 75bp hike for this week and likely will lock in another 75bp hike at the July meeting.

Friday was a data disaster. Headline CPI missed and was 1% MoM. The longer-term inflation expectations in the University of Michigan survey ticked up. And the Cleveland Fed median CPI number rose. All of this came when most thought that headline CPI for this cycle had peaked. Also, on Thursday night, the Atlanta Fed wage growth tracker rose. For the quiet period, the data was a disaster for the Fed.

Below, I examine the past few weeks, what tomorrow will look like, and where the Fed goes from here.

Where We Have Been

As has been a big theme for me, we have been in a period of central bank hawkish acceleration, and the Fed was always going to be part of it.

As I have previously written, this acceleration has four aspects:

• Recent global hikes (RBA/RBNZ/BoC/BoK).
• ECB accelerated rhetoric (going to neutral).
• The September FOMC inflection point.
• Even the SNB is beginning to move.

In this backdrop of global central bank hawkishness, it does not appear to me that the hawkish trade of higher yields is over.

The Fed was always going to be a part of this escalation, and it appears May CPI was the catalyst.

What Will Today Look Like?

For today, the only question that matters is, what do the dots look like? On the statement, the Fed has lost considerable guidance credibility – it has traded guidance credibility for inflation credibility. We will see if it works. But in terms of guidance, it is simple: the Fed will break things until it sees the number drop, and the number is inflation. As Chair Jerome Powell said in his May WSJ interview, there is no nuance. It is that simple.

In terms of the dots (economic forecasts), I think the street is broadly low both for 2022 and 2023. I think the right number for the 2022 funds rate dot has a 3 handle and that the 2023 (terminal dot) will be closer to 4%.

In fact, my theme for the dots today is a 4&4 for 2023: 4% funds rate and +4% unemployment. I think the signal for this will be like what Christopher Waller and Loretta Mester have mentioned. There will need to be some pain (labor market) to get inflation back to target, and this will be the Fed credibly showing that in their economic forecasts.

The other aspect is that the Fed has already begun to differentiate between a recession and a strong labor market. A 4.25% U3 number may equal a recession in a technical sense. But it would still be a strong labor market. This is something Powell has mentioned since May’s FOMC meeting.

The press conference could be a bit of a mess. But I think a potential theme is that a “soft landing” will be somewhat absent. The reason the Fed is erratically hiking 75bps is to lower inflation, and that is the message for today. Growth is just not part of the picture for the Fed right now. Any mention of growth dilutes the inflation message that Powell wants to deliver today. Powell ended his WSJ interview in May with five words, and those will be the theme of the press conference tomorrow: ‘get inflation back under control.’

Overall, expect closer to ‘whatever it takes’ tomorrow.

1. Fed will hike 75bp and guide to 75bp in July as well.
2. Fed will raise the terminal rate for this cycle to 4%.
3. Powell will focus on ‘a landing’ even if it not a soft one.

Where does the Fed go from here? I think the RBNZ is a very helpful guidepost and has been throughout this hiking cycle.

The June FOMC Is the Fed’s RBNZ Moment

During and even before the pandemic, the RBNZ was one of the more dovish central banks. As of almost 16 months ago, NIRP was operationally ready in New Zealand. The RBNZ was a champion of enhanced labor market outcomes at all costs. Entering Covid, and Covid included, the RBNZ was at the forefront of the dovish central bank pivot.

However, it all changed for the RBNZ at their July 2021 meeting. Since then, the RBNZ has been the hawkish leader for global central banks.

The RBNZ has led the central bank shift through the following:

1. We need to end QE.
2. We need to hike rates and get off lower bound.
3. We need to get rates to neutral.
4. We need to go faster than 25bps.
5. We need to get rates restrictive.

In 2022 so far, maybe restrictive is even higher than we thought – and maybe a lot higher than we thought. As of the May meeting, terminal in New Zealand is projected to be 3.9%.

I think the RBNZ introduced a new wrinkle for us at their May meeting: the idea of aiming for neutral, but from above. The Fed is now about to endorse this. The idea is still getting to neutral, but the starting point now will be from above.

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.)