FOMC Review: Fed Sets Out High Data Hurdle for Faster Hikes

Summary

• As expected, the Fed delivered QT and a 50bp hike.
• Powell pushed back against 75bp in June and instead pre-announced 50bp in June and July.
• He indicated inflation would have to accelerate for the Fed to tighten faster, which, regardless, would not happen until September.
• The risk is that if the Fed is wrong on inflation by September, it could have fallen further behind the curve.

Market Implications

• Curve steepening.

Fed Sets Out Weak Test for Faster Tightening

As expected, the Fed hiked 50bp and announced the start of quantitative tightening (QT). The latter will debut in June with reinvestment caps set at $30bn and $17.5bn for Treasuries and MBS, to be raised to $60bn and $35bn from September onwards.

As I expected, Chair Jerome Powell pushed back against market expectations of a 75bp hike at the June meeting. Instead, he stated that ‘50bp increases should be on the table at the next couple of meetings’.  The reason for the pushback is that the 2022 FFR path Powell set out today is already higher than the FFR path set out at the March and December meetings.  In turn, this reflects stronger-than-expected data since Q4 2021.

The test for the pace of tightening beyond the next two meetings was ‘economic and financial conditions evolving broadly in line with expectations, and core PCE inflation reaching a peak or flattening out’. That is Powell’s base-case scenario. This would require additional data, and therefore a policy adjustment would not happen until that data was available – i.e., the September meeting.

This test seems weak to me since inflation is already between 5% and 8.5%, depending on the measure used. In addition, if the Fed is wrong and inflation accelerates, by September, the Fed will have lost another three months and could find itself further behind the curve.

Fed Claims Strong Inflation-Fighting Credentials

Powell opened the presser by addressing the ‘American people’ and assuring them that ‘inflation is much too high’ and that the Fed was ‘moving expeditiously to bring it back down’.

Meanwhile, when asked ‘would this FOMC have the courage to endure a recession to bring inflation down?’, Powell’s answer was ‘Absolutely prepared to do that, wouldn’t hesitate if that is what it takes.’ Nevertheless, a soft landing remains Powell’s base-case scenario due to strong business and household balance sheets and to the ‘very strong labor market’.

Furthermore, Powell committed to bringing the FFR wherever was necessary to lower inflation. ‘We are going to be making a judgment about whether we have done enough to get us on a path to restore price stability. So if that path happens to evolve levels that are higher than estimates of neutral, we will not hesitate to go to those levels.’

Lastly, Powell expressed agnosticism towards the Fed estimate of the neutral rate: ‘It is a concept. It is not something we can identify with precision. We estimate it within broadbands of uncertainty. what we are doing really is we are raising rates expeditiously to what we see as the broad range of plausible levels of neutral. But we know that there is not a bright line drawn on the road that tells us when we get there.’

Market Consequences

Overall, the meeting added to my conviction on a terminal FFR close to 8%. The gist of the presser was the Fed is prepared to tolerate high inflation for an extended period.  The market reaction therefore makes sense to me:

• The end-2022 implied FFR fell 20bp to 2.75% from 2.95% before the presser.
• Market pricing of the terminal rate also fell: the 18m1m OIS forward swap fell 12bp.
• Long-term inflation expectations rose: 5y5y BE rose 5bp. 
• The curve steepened after the presser, the 2y yield fell 12bp and the 10y yield 3bp. 

Markets do not believe that the Fed will do what it takes to lower inflation. I expect the curve to steepen further.

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.

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