FOMC Review: More Volker Than Burns

Summary

• The Fed hiked 75bp, as expected.
• The Fed mentioned policy lags in the statement. But during the presser, Powell made clear he did not know what these were and therefore would remain driven by data developments.
• Powell announced a higher terminal rate in the December SEP and left open the possibility of another 75bp hike in December.

Market Implications

• The market is underpricing the December hike, the terminal FFR and the end-2023 FFR.
• Negative equities, further 2s10s curve inversion.

Fed Frustrated by Lack of Progress on Inflation

As consensus and I expected, the Fed hiked the Federal Fund band 75bp to 3.75–4%. The economic assessment in the statement was identical to September.

During the presser, Chair Jerome Powell made it clear that the persistence of high inflation had disappointed the Federal Open Market Committee (FOMC): ‘as the supply side problems had resolved themselves, we would have expected goods price inflation to come down by now. It has, but not to the extent we had hoped. At the same time, you see core services inflation moving up. There is no sense that inflation is coming down. We are exactly where we were a year ago.’

Powell further stressed that the labour market ‘remained extremely tight’ with ‘unemployment at a 50-year low’. Wage growth was flattening out but ‘at a level well above what would be consistent with 2% inflation’. In general, the transmission of policy tightening to the real economy had been limited. This was partly due to households’ ‘strong balance sheets and built-up spending power’ that had offset fiscal headwinds.

The one sector where policy tightening had been effective, housing, would take time to impact inflation. This is because even though the cost of new rentals was falling, those were adjusting faster than the average rent (since rents are typically reset annually).

Fed Acknowledges Policy Transmission Lags Are Unknown

The statement’s policy guidance section included a new sentence: ‘In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.’

However, during the presser, Powell also stressed that the extent of the lags was unknown. ‘The truth is, we don’t have a lot of data on inflation this high in the modern economy. One big difference is that financial conditions react well before, in expectations of monetary policy.’ He mentioned that changes in financial conditions could be transmitted faster to the real economy but stressed, ‘We don’t know that. It is highly uncertain.’

Policy, therefore, had to be based on risk management. Powell believed the Fed could more easily correct over-tightening than under-tightening. ‘If we were to over-tighten, we could then use our tools strongly to support the economy.’ By contrast, under-tightening could see high inflation persist long enough for inflation expectations to be de-anchored, which would make inflation stabilization very costly in terms of employment losses. (Interestingly, the Fed drew the opposite conclusion on the balance of policy risks during the years of low inflation.)

When asked for the staff estimate of the underlying inflation rate, Powell declined to provide a specific number. This suggests that Powell does not have an inflation model he trusts, so policy is likely to remain driven by short-term data developments. Powell stressed that policy would be informed by the broad macro picture, especially labour market developments, as well as inflation data.

The Fed’s Three Policy Parameters

Powell made it clear that ‘It’s very premature in my view to be thinking about or talking about pausing our rate hikes. We have a way to go. We need ongoing rate hikes to get to that level of restrictive [policy]. We don’t know where that exactly is.’

He sees three parameters for policy:

1. How fast to go. He viewed the current pace of tightening as ‘fast but appropriate, given the low level from which we started’. At the same time, as policy ‘move[s] into more restrictive territory, it becomes appropriate to slow the pace of increases’. And the slower pace of hikes ‘may come as soon as the next meeting or the one after that. No decision has been made’. The discussion will take place at the next FOMC meeting.

• The terminal rate. Powell announced a higher terminal rate in the December Summary of Economic Projections (SEP). Since the September meeting, ‘incoming data, both the strong labor market but particularly the CPI report, suggest to me that we may move to higher levels than we thought at the time of the September meeting.’ When asked if the real federal funds rate (FFR) would have to be positive, Powell indicated that he wanted borrowers to face real positive rates on a forward basis, for instance, based on inflation expectations. He had no guidance on when the terminal FFR would stop rising other than it was premature to discuss pausing.

• How long to stay at a restrictive level. Powell did not elaborate, possibly because the terminal FFR is still a long way away. But the hawkish tone of the presser suggests the Fed could remain restrictive until it feels confident that inflation is heading down.

Market Consequences

Powell turned out more Volker than Burns yesterday. His economic views are becoming closer to mine. Therefore, based on current data trends, I am sticking to my expectations of a close to 8% terminal FFR.

Overall, Powell successfully introduced a forthcoming slowdown in the pace of rate increases without triggering a marked easing of financial conditions. Yet markets, in my view, continue to underprice hikes. Following the meeting, they are pricing about 50bp in December, which I think is inconsistent with inflation, labour market trends, and Powell’s resolve.

Also, markets are now pricing a terminal FFR of 5–5.25%, compared with 4.5–4.75% in the September SEP. I think this is too small an increase: the September SEP expects end-2022 core personal consumption expenditures (PCE) to be 4.5%, which is likely to turn out about 75bp below the actual number. Together, with the resilience of growth and inflation to Fed tightening, it suggests a December SEP terminal rate of around 5.5%–5.75%.

Finally, markets are pricing an end-2023 FFR at 4.75%. The stickiness of inflation suggests that the Fed will remain at the terminal rate far longer than markets expect. I therefore expect an end-2023 FFR close to 8%.

This would be negative for risk assets and imply further curve inversion.

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.)