Monetary Policy & Inflation | US
FOMC Review: Falling Further Behind the Curve?
- By Dominique Dwor-Frecaut
- 4 min read
Summary
- As expected, the Fed delivered quantitative tightening and a 50bp hike.
- Powell pushed back against 75bp in June and instead pre-announced 50bp in June and July.
- He indicated inflation would have to accelerate for the Fed to tighten faster, which, regardless, would not happen until September.
- The risk is that if the Fed is wrong on inflation by September, it could have fallen further behind the curve.
Market Implications
- Higher long-term yields, with the equity rally unlikely to last.
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Summary
- As expected, the Fed delivered quantitative tightening and a 50bp hike.
- Powell pushed back against 75bp in June and instead pre-announced 50bp in June and July.
- He indicated inflation would have to accelerate for the Fed to tighten faster, which, regardless, would not happen until September.
- The risk is that if the Fed is wrong on inflation by September, it could have fallen further behind the curve.
Market Implications
- Higher long-term yields, with the equity rally unlikely to last.
Fed Sets Out Weak Test for Faster Tightening
As expected, the Fed hiked 50bp and announced the start of quantitative tightening (QT). The latter will debut in June with reinvestment caps set at $30bn and $17.5bn for Treasuries and MBS, to be raised to $60bn and $35bn from September onwards.
As I expected, Chair Jerome Powell pushed back against market expectations of a 75bp hike at the June meeting. Instead, he stated that ‘50bp increases should be on the table at the next couple of meetings’. The reason for the pushback is that the 2022 FFR path Powell set out today is already higher than the FFR path set out at the March and December meetings. In turn, this reflects stronger-than-expected data since Q4 2021.
The test for the pace of tightening beyond the next two meetings was ‘core PCE inflation reaching a peak or flattening out’. That is Powell’s base-case scenario. This would require additional data, and therefore a policy adjustment would not happen until that data was available – i.e., the September meeting.
This test seems weak to me since inflation is already between 5% and 8.5%, depending on the measure used. In addition, if the Fed is wrong and inflation accelerates, by September, the Fed will have lost another three months and could find itself further behind the curve.
Market Consequences
Overall, the meeting added to my conviction on a terminal FFR close to 8%. The gist of the presser was the Fed is prepared to tolerate high inflation for an extended period. This is likely to see the Fed fall further behind the curve, and eventually capitulate and go for a much higher terminal rate than currently.
The market reaction that took out rate hikes and saw an equity rally therefore makes sense to me. At the same time, long-term breakevens and nominal yields rose, which suggests the markets are having doubts the Fed strategy can work. For that reason, I do not expect the equity rally to last.
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 publishes the blog Macro Sis that discusses the drivers of macro returns.
(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.)