FOMC Preview: Would Resilient Growth Lead to More Hikes?

Summary

• With a 25bp hike a done deal, no SEP, and Chair Jerome Powell unlikely to provide hints on the September FOMC, the most interesting development at next week’s Fed meeting would be clarification of the reaction function.
• While the Fed’s reaction to inflation surprises is clear, the reaction to growth surprises is more ambiguous.
• Growth resiliency has surprised both FOMC hawks and doves: the doves believe it means Fed tightening has yet to be fully transmitted to the real economy; the hawks think it signals policy is insufficiently tight.
• So far, Powell has sided with the doves. But the longer growth remains above trend, the weaker the doves’ position.
• Next week’s meeting could tell us what might shift Powell’s views.

Market Implications

• I continue to expect an additional hike at the November FOMC meeting.

FOMC Meeting to Indicate Medium-Term Reaction Function

A 25bp hike next week is a done deal, and there will not be a Summary of Economic Projections (SEP). So what are we likely to learn from this meeting? 

Not much about the September FOMC: Chair Powell is unlikely to provide pointers, yet. He likely will restate that the Fed ‘will continue to make its decisions meeting by meeting   based on the totality of the economic data and their implications for the outlook for economic activity and inflation as well as the balance of risks’.

This meeting is more likely to provide information about the Fed’s medium-term reaction function. The current SEP shows one more 2023 hike and 100bp in 2024 cuts. How would the Fed react if actual macro data differs from the SEP?

The Fed’s Reaction to Growth Surprises Is Ambiguous

The Fed’s reaction to a deviation of core PCE from the SEP path (3.9% in Q4 2023 followed by 2.6% in Q4 2024) is fairly clear. Higher actual core PCE relative to the SEP projections would likely see the FFR higher for longer and vice versa (the Fed could also react by lifting its inflation forecast, as it has done since 2021).  

The Fed’s reaction to higher-than-expected growth is more ambiguous. Until the March 2022 SEP, the Fed expected 2023 growth to remain above trend of 1.8%. Only from the June 2022 SEP did the Fed project 2023 GDP growth below trend (Chart 1). This likely reflects that by the June 2022 meeting, the FOMC had realized that returning inflation to target would require more aggressive policy than initially anticipated, and it revised its 2023 growth forecast accordingly. 

Growth, however, has turned out more resilient than the Fed expected. It rebounded in Q3 2022, and the Atlanta Fed GDP nowcast expects 2.4% QoQ SAAR for Q2 2023 (Chart 2). Yet core PCE has not accelerated, giving the Fed leeway in its response to higher-than-expected growth.

Doves Expect Longer Lags

Neither doves nor hawks are questioning the long-term relationship between growth and inflation, i.e., that a continuation of the ongoing growth acceleration would lead to higher inflation. Rather, hawks and doves have different interpretations of the growth acceleration. 

For the hawks, resilient growth reflects that policy tightening has been fully transmitted to the real economy – and fallen short. Their key arguments are:

• Fed tightening started when markets started pricing hikes, six months ahead of the actual hikes (Mester, Waller, Logan).
• The real FFR is low relative to previous Fed tightening cycles (Mester).
• Financial conditions have not tightened since Q3 2022 (Logan).
• The estimation of transmission lags is biased (Waller).
• The tightening of credit conditions is in line with previous Fed tightening cycles (Waller, Mester, and Logan).

By contrast, the doves believe that resilient growth reflects that most of the policy tightening of the past 18 months and most of the impact of the banking crisis have yet to be transmitted to the real economy (Bostic, Daly, and Williams). Unlike the hawks, the doves lack specific macro evidence to support their view other than Williams’ estimate of the natural rate of interest at 0.5%. Adjusted for inflation and the term premium, this suggests an FFR around 1.25% to 1.5%.

So far, Powell has sided with the doves. Part of the reason for his caution could be the recently announced shrinkage in regional banks’ balance sheets, which investors discovered when banks published their quarterly results but of which the Fed was likely apprised in real time. In addition, Powell could be concerned that the Fed’s planned increased in capital requirements for medium-sized banks could further tighten credit availability.

Powell could communicate how long he is prepared to wait for signs of transmission of policy tightening. Alternatively, he could describe which sectors of the economy he sees as most likely to be impacted by policy tightening. For instance, in June Powell acknowledged that housing, which he sees as ‘very interest rate sensitive’, is ‘putting in a bottom and may be even moving up a little bit’. Further acknowledgment of the recovery in residential real estate could signal that Powell is moving closer to the hawks and could support hikes above the two already planned for the remainder of 2023 if the economy continues to strengthen.

Market Consequences

Coming into next week’s meeting, I expect one additional hike in November. This is based on Powell’s view in his statement that ‘it seems to us to make obvious sense to moderate our rate hikes as we get closer to our destination’. Since up to May 2023 the FOMC has been hiking at each meeting, I read Powell’s statement as implying a hike every other meeting.

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.)