FOMC Review: On Balance, Hawkish

Summary

• The Fed hiked 50bp, as expected.
• The SEP was more dovish than I expected and continued to show a soft landing largely based on “immaculate disinflation”
• The presser was hawkish with Chair Powell ruling out an increase in inflation target anytime soon and leaving open the possibility of a further increase in the terminal FFR

Market Implications

• The market is underpricing the terminal and the end-2023 FFR. 
• Market pricing of the February meeting at 30bp is below my expectations of 50bp.

Dovish SEP

As consensus and I expected, the Fed hiked the FFR 50bp to 4.4% at the meeting on Wednesday.

The SEP showed an increase in the median 2023 dot to 5.1%, against the 5.4% I was expecting. This is possibly because the doves, emboldened by recently lower inflation prints, are getting more dovish (Chart 1). 

The SEP continued to show a soft landing based on ‘immaculate disinflation’. The gap between the SEP-implied Taylor rule and nominal FFR was unchanged from the September SEP, and the SEP implied real 2023 dot increased by 10bp only (Chart 2). 

In addition, the Fed raised its 2023 core PCE forecast by 40bp relative to the September SEP (Chart 3). When asked why policy was not targeting a lower PCE in 2023, Chair Jerome Powell did not provide an explanation but simply stated that the 2023 PCE forecast reflected a higher outturn in 2022.

Hawkish Presser

Despite this dovish SEP, I expect the Fed to stick to its mandate and lift the FFR trajectory once the data shows inflation is accelerating again, around mid year (November 2022 CPI Inflation Trends Remain Strong). 

This reflects in part today’s presser:

• Powell made it clear that an increase in the inflation target is unlikely anytime soon: ‘we’re not considering that and not going to consider that under any circumstances.’ This was as I expected, but it is still good to hear Powell say it.
• Powell stated clearly that ‘we are not at a sufficiently restrictive stance yet’.
• He stressed that, while lower CPI prints in October and November were welcome, ‘it will take substantially more evidence to give confidence that inflation is on a sustained downward path.’
• Powell did not rule out a further increase in the terminal FFR: ‘I can’t tell you confidently that we won’t move up our estimate of the peak rate again at the next SEP.’
• He did not rule out another 50bp hike in February: ‘we’ll make the February decision based on incoming data and financial conditions.’

I also expect Powell, whose mandate does not expire until May 2026, to be focused on his legacy and to center his action on inflation stabilization.

The risk, however, is that the Fed will lift its FFR trajectory only once it has become clear that inflation is moving to a higher path, i.e., too late. I am surprised that recent Fed chatter has not mentioned the risks that lower energy prices could be behind the recent decline in core inflation. Risks of spillovers from energy prices to core inflation were highlighted in a famous 2015 speech by then Fed Chair Yellen. I guess bureaucracies such as the Fed can have surprisingly short memories.

Market Consequences

The market is pricing a terminal FFR about 25bp below the SEP and an end-2023 FFR 75bp below the SEP, i.e., 50bp cuts after the Fed hits the terminal rate in Q2 2023.

I disagree. Shorter term, as Powell explained, the Fed’s game plan will be driven by data and financial conditions. The market reaction to Wednesday’s FOMC meeting suggests a further easing of financial conditions.  Together with strong employment growth and moderate inflation prints, this could support a 50bp hike in February, compared with about currently 30bp priced in.

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 joined Macro Hive soon after its inception.

(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.)