FOMC Preview – Emerging Inflation Risks

Summary 

• I expect the Federal Reserve (Fed) to stay on hold and the SEP to show: 
  • One more 2023 hike. 
  • Two 2024 cuts instead of four in the June SEP. 
  • Unchanged inflation trajectory. 
  • Higher growth trajectory. 

• Because of rising inflation risks, I expect the next 2023 hike to happen at the November meeting rather than the one in December. 

Market Implications 

• I do not expect Chair Jerome Powell to change market expectations of only a 50% chance of an extra 2023 hike or of four 2024 cuts. Rather, I expect the Fed to gradually jawbone the markets into fully pricing an extra hike by the 1 November meeting. 

New Appointments Support the Doves 

Since the July FOMC meeting, there have been three key developments: new personnel, higher-than-expected growth, and a surge in oil prices.   

Regarding new personnel, Vice Chair Jefferson, and Governors Cook and Kugler have been sworn in, Jefferson for four years, Cook for 15 and Kugler for three. I rate Cook and Kugler 0.25 and Jefferson 0.5 on my dove (0.25)/hawk (1) scale. Governor Kugler has yet to opine on the economy. But based on her background as a labour economist and on her getting approval from the Biden administration, I peg her as a dove.  

Jefferson’s promotion to Vice Chair and Cook’s nomination for a second, full term could increase their influence. However, neither has publicly spoken on the economy since June.  We have yet to see how they will use their new positions to make their mark on Fed thinking and policy. 

Another new FOMC meeting participant is Jeffrey Schmid, who replaced Esther George as president of the KC Fed. Like Kugler, he has yet to speak publicly as a Fed official, but for now I rate him 0.75 (i.e., as hawkish as Powell). This is because of his background as CEO of Southern Methodist University Business school and his appointment as head of a Fed located in ‘Red America’ (Schmid’s district includes Colorado, Kansas, Nebraska, Oklahoma, Wyoming, and parts of Missouri and New Mexico). 

On balance, the new appointments have likely strengthened the Fed’s dovish bias (Chart 1 in Fed Monitor). That said, a dovish Fed is a not a Fed that never hikes. Rather, it is a Fed that requires strong evidence that inflation is costly to society before taking steps that could harm growth or employment. 

An Unwelcome Positive Growth Surprise 

Since the July meeting, growth has surprised on the upside, with the Atlanta and NY Feds nowcasts showing Q3 growth at 5.6% and 2.3%, respectively, well above the FOMC estimate of trend at 1.8% and inconsistent with the June SEP Q4 2023 GDP growth forecast at 1% YoY. 

As a result, in his Jackson Hole speech, Powell has been more tentative in assessing the restrictiveness of monetary policy than he was at the June FOMC presser. Specifically, he said ‘We are attentive to signs that the economy may not be cooling as expected. Additional evidence of persistently above-trend growth could put further progress on inflation at risk.’ 

However, despite higher-than-expected growth, core PCE is still on track to finish the year in line with the June SEP forecast of 3.9% Q4/Q4, though December YoY core PCE will likely be lower. Even if core PCE rose by only 0.2% from now to December 2023, Q4/Q4 would still be 3.8% (Table 1). 

The Fed knows that the current combination of slowing core inflation and accelerating growth is unsustainable: in the longer run either inflation has to rise or growth has to slow.  Since there is not enough data yet for doves and hawks to reach a consensus on which is more likely, Powell is likely to look for a compromise move. 

The compromise could consist of leaving one more 2023 hike in the SEP, since inflation is behaving as expected in the June SEP, and of reducing the number of cuts in 2024.   

Cleveland Fed president Mester (non-voter, hawk) has already indicated in a JH interview that she would upgrade her 2023-24 growth projections and reduce the number of 2024 cuts.   

Meanwhile, Chicago Fed president Goolsbee’s implicit agreement on another 2023 hike (‘the Fed is almost done hiking’) suggest convergence between hawks and doves. 

Based on emerging risks of inflation acceleration, I expect the median number of 2024 cuts to fall to two from four in the June SEP (August CPI review). 

Higher Oil Prices Is Another Unwelcome Surprise 

The other development since the June FOMC is the rally in oil prices, with WTI now at $88/barrel against $80/barrel in late July (Chart 1). Traditionally, central banks tend to get concerned by rising energy prices because of their impact on inflation expectations and of the risk of passthrough to core inflation (see August CPI review).   

There is not enough data yet for Fed hawks and doves to agree on whether the ongoing oil price spike is sustainable and whether there is a risk of passthrough to core inflation. Nevertheless, the acceleration in core inflation in August has been accompanied by a marked increase in energy prices. This has likely put Powell on alert, and as a result he might try to talk tough during the presser. 

My expectations for the meeting are: 

1. No hike. 

2. SEP to show: 

• One more 2023 hike: Powell will insist that the timing will remain data dependent but November seems to me more likely than December considering rising inflation risks. 
• Two 2024 cuts. 
• Higher 2023 and 2024 growth forecast. 
• No change to the inflation forecast. 

Market Consequences 

I do not expect the FOMC meeting to change markets expectations of only a 50% risk of an additional hike in 2023 and four cuts in 2024. Pricing of a full hike by the 1 November meeting is likely to happen more through Fedspeak than data releases, since the Fed’s extra 2023 hike is based on current data developments and markets do not believe those justify a hike. 

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.)