Monetary Policy & Inflation | US
FOMC Review – Fed Still Plans Gradual Normalization
- By Dominique Dwor-Frecaut
- 4 min read
Summary
• Against my expectations, the Fed was incrementally more hawkish at the January meeting today.
• My risk case of five hikes in 2022 is now my base case, starting with a 50bp hike at the March FOMC meeting.
• The Fed’s game plan of gradual policy normalization remains and is unlikely to change until end-year as Chair Jerome Powell expects H2 improvements in supply.
Market Implications
• Although I think money markets are underpricing 2022 hikes, a bond and equity rally is still possible as the economy could return to TINA after Q1.
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Summary
- Against my expectations, the Fed was incrementally more hawkish at the January meeting today.
- My risk case of five hikes in 2022 is now my base case, starting with a 50bp hike at the March FOMC meeting.
- The Fed’s game plan of gradual policy normalization remains and is unlikely to change until end-year as Chair Jerome Powell expects H2 improvements in supply.
Market Implications
- Although I think money markets are underpricing 2022 hikes, a bond and equity rally is still possible as the economy could return to TINA after Q1.
Five 2022 Hikes in the March SEP Is Likely
Contrary to my expectations, the Fed was incrementally more hawkish today. As I expected, it kept asset purchases on through March and announced a March liftoff. But against my expectations, it did not hint at a mid-year start to QT2. The overall tone was somewhat more hawkish than I expected.
My risk case of five hikes is consequently now my base case scenario. Also, I expect a 50bp hike at the March FOMC as the real Fed Funds rate (RFFR) currently at -5.5% is the lowest since the 1950s and would remain so even after a 50bp hike.
Furthermore, Chair Jerome Powell conveyed strong confidence in the outlook: ‘Fortunately, health experts expect that cases will drop off rapidly. If the wave passes quickly, the economic effects should as well, and we would see a return to strong growth’. Also, he stated that ‘The labor market is very, very strong right now and I think that strength will continue.’
Five hikes seem to be about right:
- Powell did not push back against market pricing of Fed hikes, four before the meeting and 4.5 afterwards: ‘our communication channel with the markets is working’.
- Powell indicated that ‘since the December meeting I would say that the inflation situation is about the same but probably slightly worse. I’d be inclined to raise my own estimate of 2022 core PCE inflation, let’s go with that by a few tenths today.’
Powell Protected Policy Optionality
Meanwhile, Powell did not convey a fundamental change to the Fed’s long-term game plan, namely a return to an RFFR of 0% over three years. We must place today’s hawkish comments in the context of policy normalization. As Powell stated today, ‘In light of the remarkable progress we have seen in the labor market and inflation that is well above our 2% longer-run goal, the economy no longer needs sustained high levels of monetary policy support’.
Furthermore, while today Powell said that ‘inflation risks are still to the upside in the views of most FOMC participants’, this is no news. Most FOMC participants have seen inflation risks tilted to the upside since the June 2021 SEP.
In this context, Powell did not signal a radically faster pace of normalization. Rather, he avoided providing details on policy normalization that would have reduced policy optionality. For instance:
- ‘It is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate.’
- ‘We know that the economy is in a very different place than it was when we began raising rates in 2015’. This statement was already mentioned in the December minutes and does not imply radically faster normalization than that currently priced in. In 2015, the Fed Funds was increased once, then not increased again for another year.
- ‘We are willing to move on the balance sheet sooner than we did the last time and also perhaps faster’. Again, this was already mentioned in the December minutes. It also tells us little, since 2015-17 saw a 2.5-year gap between liftoff and QT1, and we already know that this time quantitative tightening (QT) will start by end-2022. That is, within months of liftoff.
The risks of a change in the Fed’s long-term game plan are more likely at the end of 2022 if the supply improvements Powell expects in H2 have not materialized.
Market Consequences
I see a risk of further curve flattening as the market is currently pricing 4.5 hikes against the five I now expect. Also, I believe the Fed is overestimating the strength of the labour market and see a risk that the unemployment rate could stabilize or even rise somewhat from current levels in H2.
That said, there is no sign yet the Fed is giving up on gradual policy normalization. In that sense, the equity market selloff seems unwarranted.
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.)