Monetary Policy & Inflation | US
The September FOMC meeting has shown all the signs of an extremely difficult communication challenge. But the best place to start is the market backdrop entering the meeting.
This backdrop is obviously fairly negative given the Evergrande news and continued concerns about a rolling deleveraging in the Chinese property sector. Yet a bigger picture macro concern appears to be weighing on risk assets.
From the market’s perspective, the very near-term distribution has become simpler; either growth hits its expectation, or it misses. The current state of the supply side just will not allow data beats. So, over the rest of the calendar year, growth is biased lower. The other element complicating this dynamic is that no dovish Fed offset is on the horizon. As the Fed is on autopilot regarding taper and will likely be very conscious of the medium-term growth/inflation forecast, it is not meeting growth misses with a dovish shift. This duality is seemingly a problem for risk assets, especially entering the meeting itself.
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The September FOMC meeting has shown all the signs of an extremely difficult communication challenge. But the best place to start is the market backdrop entering the meeting.
This backdrop is obviously fairly negative given the Evergrande news and continued concerns about a rolling deleveraging in the Chinese property sector. Yet a bigger picture macro concern appears to be weighing on risk assets.
From the market’s perspective, the very near-term distribution has become simpler; either growth hits its expectation, or it misses. The current state of the supply side just will not allow data beats. So, over the rest of the calendar year, growth is biased lower. The other element complicating this dynamic is that no dovish Fed offset is on the horizon. As the Fed is on autopilot regarding taper and will likely be very conscious of the medium-term growth/inflation forecast, it is not meeting growth misses with a dovish shift. This duality is seemingly a problem for risk assets, especially entering the meeting itself.
Regarding China and the Evergrande mess, I think the interaction between China macro, the Fed and US macro is underdiscussed. There is an element of China concerns and Fed hawkish fears feeding off each other, especially when US growth expectations are being revised lower.
Zooming out, Chinese macro policy became a big bet on US growth as it attempted to replace its credit impulse via the current account. China tightened credit while the external-account surplus blew out. This allowed it to import the aggregate demand it was ‘sacrificing’ by reducing credit growth. So, while China attempted to push credit growth in line with nominal GDP – as the PBoC said it would do in Q1 – there was an implicit handoff in demand impulses from credit to exports.
This starkly contrasts the 2018 credit tightening. China’s current account surplus in this credit tightening phase is over 2% of GDP versus almost flat in 2018. China has seemingly attempted to calibrate its domestic policy stance relative to how much aggregate demand it is importing from the US, and the external account has ‘allowed’ China to reign in credit excess.
The problem is, China is a big bet on US demand right now, and US growth has weakened in Q3. It may be fine, but China in their current policy posture needs it to be huge. Fine may be insufficient. This duality seems to be weighing on the market and risks China concerns being amplified by the US slowing into a trapped Fed. And these three factors are seemingly feeding off each other.
The Fed Formalizes ‘Advance Notice’
The Fed has told us in the minutes, press conferences and speeches that they will give the market ‘advance notice’ of when they think ‘substantial further progress’ will be achieved. The September meeting is likely when they will formalize ‘advance notice’ into the statement.
July guidance on taper: ‘Since then, the economy has made progress toward these goals, and the Committee will continue to assess progress in coming meetings.’
September: ‘The economy is on track to achieve substantial further progress toward its maximum employment and price stability goals.’
However, the Fed will surely have an out, especially given the recent market volatility. The point of preannouncing or guiding taper is that if the economy or markets do not evolve in line with FOMC expectations, it has room to delay. This will be in the statement, as in 2017, and Chair Jerome Powell will surely emphasize it in the press conference.
Substantial further progress sequencing:
- April minutes: it could be time to begin discussing taper. ‘A number of participants suggested that if the economy continued to make rapid progress toward the Committees goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.’
- June press conference: Powell calls it the ‘we talked about talking about it meeting’.
- July statement: the Fed acknowledges progress in the statement via language from the June minutes. ‘The economy has made progress toward these goals, and the Committee will continue to assess progress in coming meetings.’
- July minutes: the taper announcement is a 2021 event. ‘Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s “substantial further progress” criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum employment goal.’
- September statement: the Fed acknowledges the economy is ‘on track to achieving substantial further progress’, which will serve as ‘advance notice’ for a November announcement.
In terms of taper’s effect on financial conditions, the Fed has been successful in avoiding a tantrum-type episode. However, the next financial conditions question is predicated on the Fed’s ability to continue this ‘de-link’ theme, where they communicate that the bar to raise interest rates is a ‘different and substantially more stringent test’ than taper, as Powell said at Jackson Hole. However, the market has become sceptical of how this plays out in practice, especially given the new SEP and dot plot that will come out at this meeting.
The Dot Plot Mess
The Fed’s problem with the ‘de-link’ message is the context in which it will likely occur. The Fed will announce they are on track to begin tapering asset purchases. However, the reaction function for taper is different from that for rate hikes. Or, as Powell said in his Jackson Hole speech, rate hikes operate on a ‘different and substantially more stringent test.’ The problem with this in practice, as opposed to theory, is that at the meeting where Powell will be saying it, the dots will show the Fed expects to hike at least two times in 2023 and three times in 2024. It is hard to see how the dots do not dilute Powell’s message of ‘different and substantially more stringent.’
The other discomfort for Powell with the dots is that the SEP will show a rise in the inflation forecast and a drop in the growth one. The Fed will have to raise its inflation forecast for 2021 considerably from 3%, likely to slightly below 4%. And the June forecast of GDP at 7% will likely need revision to maybe even below 6% on the back of a disappointing Q3.
This duality is partly why the US treasury curve has been in this relentless flattener. On the one hand, the Fed is less able to embrace good outcomes (pro-cyclically) with inflation this high. But on the other, it is also limited in its countercyclical posture given the inflation level. This is why the June pivot was so significant: it created policy asymmetries the Fed would rather avoid.
Arguably, the key period to watch will be the 2022 dots. And it is not to see if two more FOMC participants join the seven calling for a hike and move the median to one rate hike next year. It is to see the Fed’s growth and inflation forecast. On growth, the Fed should be able to raise its GDP forecast from the June projection on the back of supply issues pushing more growth into 2022. That is, some of the 2021 growth downgrade gets pushed to 2022. However, on inflation, 2.1% seems low, and if that starts drifting higher it may not put pressure on the 2022 rate dots, but it may begin to move the 2023 dots considerably.
Press Conference
Powell will probably try to hammer home his Jackson Hole theme at the press conference: taper is happening this year; it has no bearing on the interest rate path. Regarding the dots, Powell will have to acknowledge that uncomfortable duality of the 2021 revisions (lower growth, higher inflation). But he will also emphasize that recent inflation prints have emboldened the transitory camp and that growth is not being lost but deferred. However, Powell must juggle many balls, and the takeaway from this meeting may be similar to the June SEP – the dots are in control.
Overall
To me, the September FOMC’s key theme is that the Fed is still in its post-June transition phase. Zooming out, we can say the Fed has operated this year in two phases: before and after the June meeting. Before the June meeting, the Fed was all about its reaction function. The data would come in hot, and the Fed would say, ‘look at FAIT’. After June and the inflation flinch, the Fed is all about the data and much more data dependent than FAIT obsessed.
Being data dependent in this meeting is tricky, as we noted above. The near term and medium term disagree, the market backdrop is tricky given rising external risks, and the Fed is trying to pitch the optionality game when the market wants clarity.
Overall, this gives Powell a very large communication challenge. On the Fed more generally, it is by no means hawkish, it is just less dovish. And we are still in the adjustment phase of this delta (rate of change).
Jon Turek is author of the Cheap Convexity blog and CEO of JST Advisors.