FOMC Preview: Will the Fed Walk the Talk?

Summary

• The Ukraine crisis has further widened the imbalance between supply and demand, suggesting inflation may not lower without substantial policy tightening.
• The Fed has been talking up its inflation-fighting credentials but indicated it would be in wait-and-see mode this week.
• As a result, I expect a 25bp hike and the March SEP to show only five hikes in 2022.
• I expect the Fed to eventually hike six times in 2022, more than in the March SEP but less than necessary to stabilize inflation.
• As a result, the Fed could have to hike more in 2023, possibly as much as 250bp, which would likely lead to a hard landing. 

Market Implications

• The market is underpricing 2023 hikes.

The Ukraine Crisis Has Increased Inflation Risks

I was expecting the switch from goods to services consumption to trigger a downside move in inflation. But I am now thinking that the Ukraine crisis makes it unlikely for two key reasons (Inflation Slowdown to Accelerate After Q1). First, the crisis will add to the intensity and duration of supply bottlenecks and the supply-demand imbalance. Second, the Fed is likely to fall further behind the curve.

The 2008 oil price shock had no impact on core inflation. This time, it could have a lasting impact for the following reasons:

• Oil prices are likely to stay elevated for an extended period. In 2008, oil prices peaked at $145/barrel in early July. By end-2008, they were below $35/barrel. This time, oil prices are likely to remain high. This is because Russian energy exports, which before the crisis represented 10% of the world total, are unlikely to normalize soon (Ukraine Conflict Could Trigger Oil Shock and Global Recession). 
• The fast decline in oil prices in 2008 reflected the Global Financial Crisis (GFC). Now, though, while real household incomes are falling due to inflation, a deflationary shock of the magnitude of the GFC appears unlikely. US growth is relatively sheltered from a commodities price shock as its imports of commodities roughly match its exports.
• The Ukraine crisis is adding a new negative supply shock to the one already created by the pandemic, which will add to the supply demand imbalance. This is happening when, by contrast with 2008, the Fed is already far behind the curve, with the real Feds Funds rate (RFFR) the lowest since WWII.
• The Cleveland Fed median CPI, which only keeps the price change at the centre of the distribution, is higher now than in 2008. This suggests more generalized price pressures this time (Chart 1). 

I still think that the structurally disinflationary environment that existed before the pandemic has not changed. However, a double supply shock when inflation is already high and becoming broad based, and the Fed is behind the curve, suggests inflation persistence and a marked growth slowdown ahead. I still expect that once this cycle is behind us, inflation will return to its low pre-crisis trend.

The Fed Talks the Talk, But Will It Walk the Walk?

During last week’s semi-annual testimonies to Congress, Fed Chair Jerome Powell stressed that if inflation did not slow as he expected, he would accelerate tightening, even if growth disappointed.

Yet Powell stated that he supports a 25bp hike for the 16 March FOMC meeting and that the Fed would ‘proceed along the lines that we had in mind before the Ukraine invasion happened’. This is because the Fed needs time to assess the war’s impact. I therefore expect next week’s median 2022 dot to show five hikes. Powell also said that he expects ‘good progress on a plan to shrink the balance sheet’. I think that hints at quantitative tightening (QT2) starting around midyear.

I expect the Fed to eventually hike by more than the five hikes likely to be included in this week’s SEP, but not by much. This could see headline and core inflation approach double digits from currently 6% and 5% YoY. As a result, the Fed may have to tighten strongly in 2023 – for instance, hike by 250bp. That would cause a recession.

Market Consequences

I think the market is underpricing 2023 hikes. This could reflect market concerns over growth and the Fed’s willingness to hike in a slowdown, as shown by the recent rise in long-term breakevens and drop in real rates.