FOMC Review – Fed Still Plans Gradual Normalization
(4 min read)
(4 min read)
• 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.
• 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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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:
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:
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.
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.
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