FOMC Preview: Three Themes on the Path to a Dovish Taper

Much has changed since the April FOMC meeting. We have had two high inflation prints, employment gains have been slower than consensus estimates, and the Fed has introduced language that at some point this year it may be appropriate to reduce the pace of asset purchases.

I have broken my Fed preview down by sections and by what I will watch for in each.

Statement

In the statement, do we get any more language on ‘transitory’? Right now, the second paragraph about inflation says, ‘inflation has risen, largely reflecting transitory factors.’ It will be interesting to see if the Fed adds to that. This could serve to embolden ‘transitory’ via adding duration. The big theme to watch in general for the Fed this summer is whether ‘transitory’ evolves from a few months to maybe a year. The second paragraph will be important on that front.

SEP (Dots)

For the SEP, the key thing I will watch is the intersection between the core PCE forecast and the 2023 fed funds dot. This is a very similar theme to that of the March SEP. In March, the Fed’s forecast for 2021 GDP was 4.2%, and the market was thinking somewhere between 6% and 7%.

The problem was not that the forecast from the December meeting was wrong, but that it was in a sense diluting the efficacy of the Fed’s forward guidance. The way the Fed adds legitimacy to the 2023 fed funds dot, which has de facto become the markets’ litmus test for FAIT, is to revise up growth and inflation without changing the timing for rate hikes. They passed in March, and I think they will pass again in June.

The only thing to watch for is the 2022/23 PCE dots. Were those to rise, I think the Fed can sell a rise in the 2023 fed funds dot in a dovish fashion. In terms of the 2023 dot by itself, I do not think it rises unless the medium-term inflation forecast were to rise with it. That would require many strong takeaways from the recent data, which would conflict with the Fed’s message of transitory and noisy.

Press Conference

As we will get no reference in the statement, the focus of the press conference will be on taper. This has only been enhanced by the April minutes and Vice Chair Richard Clarida. Both said it may soon be appropriate to begin discussing a taper. As Clarida stated, ‘it may well be in upcoming meetings; we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases.’

There are two things to watch on this front as I think Chair Jerome Powell will be less dismissive of taper than he was in the April press conference. Back then, he said, ‘The time is not now. We’ve had one great jobs report. It’s not enough.’

The Fed has set up two key transition points that will both serve as buffers to taper but will also acknowledge we are getting closer.

1. Governor Lael Brainard’s progress => substantial further progress
2. Begin discussing => discussing

In her speech just a few weeks ago, Brainard said, ‘We are seeing welcome progress and I expect to see further progress in the coming months.’ So, what Brainard is saying is, we are in a better position than we were, but the progress has not been substantial yet. I think this will be heavily echoed in the press conference on Wednesday.

The language around taper in the April minutes was very interesting:

‘A number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.’

A few obvious takeaways: first, the progress on the economy had to be ‘rapid’ just to begin discussing taper at upcoming meetings (plural).

Since the April meeting, the Fed has set out a very clever sequencing bar regarding taper. It both acknowledges that progress is being made but also further creates buffers between the discounting mechanism (the market) and the actual event (taper). The Fed is telling you they are going to taper; it is inevitable, but look at what you need to get through first.

• They must acknowledge they have begun discussions, as opposed to where they are now (they may begin discussions).
• Brainard’s progress must be ‘rapid’ and then become ‘substantial’.

In case there was any doubt, the Fed is on a path to making taper a dovish event. The Fed will taper; they are telling you that, but they are also saying the path matters.

Overall

This will be a very interesting meeting. In an ideal world, the Fed wants to say, see you in September as the data is just too noisy right now. That said, I think there are three themes we will get from this meeting, and they are important in terms of the Fed reinforcing their reaction function into this data blackhole.

First, the economy is making progress. It may not be substantial, but it is progress. I expect Powell to echo that message from Brainard’s speech a few weeks ago.

Second, the Fed is focused more on calibration than data right now. It appears a shift is happening at the Fed, and the focus is becoming more on policy durability than data. The Fed is withdrawing from max accommodation to durability (protecting FAIT). The proof has been that despite the suboptimal employment readings since April, the Fed has furthered the taper narrative.

The last thing to watch is for any expansion of language around ‘transitory’. I think it is coming, but I am unsure it will be as soon as this meeting. The April minutes read:

‘Looking further ahead, participants expected inflation to be at levels consistent with achieving the Committee’s objectives over time. A number of participants remarked that supply chain bottlenecks and input shortages may not be resolved quickly and, if so, these factors could put upward pressure on prices beyond this year.’

I think Wednesday goes dovish, just because the bar to get the 2023 dot higher is very high and the market is obsessed with it. However, that misses the point and the message the Fed is trying to get across.