FOMC Review: Greater Risks of 2023 Hard Landing

Summary

• The Fed hiked the FFR 25bp as expected. The SEP showed 175bp hikes in 2022.
• The positive equity market reaction to the March FOMC likely reflects that monetary policy remains gradual and reactive, despite the higher-than-expected 2022 hikes.
• Yesterday’s SEP is consistent with my reactive policy scenario that entails risks of large tightening and a hard landing in 2023.    

Market Implications

• The market is underpricing the end-2022 and end-2023 FFR.

The Fed Acknowledges the Impact of the Ukraine Crisis on Inflation…

As expected, the Fed hiked the Fed Funds rate (FFR) 25bp. And in line with market pricing, the Summary of Economic Projections (SEP) showed 175bp hikes in 2022. Chair Jerome Powell further hinted that assuming market stability, quantitative tightening will likely start in May. 

I was only expecting the SEP to show 125bp hikes in 2022 given Powell’s statement at his Congressional testimonies on 2 and 3 March (FOMC Preview – Will the Fed Walk the Talk?).     Two weeks ago, Powell said it was too soon to assess the impact of the Ukraine crisis and that he would stick to normalization plans devised before the invasion.

Yet today’s FOMC statement said, ‘The invasion of Ukraine by Russia is likely to create additional upward pressure on inflation and weigh on economic activity.’ The higher than expected 2022 hikes likely reflected the Fed’s decision to account for the higher inflation risks caused by the Ukraine crisis.

The Fed’s change of tack could reflect that it is now more confident the Ukraine crisis will persist. It could also reflect criticism from GOP senators during Powell’s testimony that the Fed has fallen behind the curve.

…But Remains Gradualist

The curve flattened, and the equity market rallied. I think the equity market reaction reflects that, despite the seven hikes planned for 2022, the Fed remains gradualist:

• The March SEP shows only a mild impact from the Ukraine crisis on inflation: the gap between headline and core inflation increased to 20bp and 10bp in 2022 and 2023, from -10 bp and zero in the December SEP.
• The Fed is allowing inflation to remain higher for longer, rather than tightening faster. This is shown by an increase in 2022 core PCE to 4.1% from 2.7% in the December SEP and an increase in the 2024 core PCE to 2.3% from 2.1% in the December SEP.
• The Fed’s strategy is still to wait for inflation to slow by itself before stepping up policy normalization. During the presser, Powell acknowledged that ‘part of inflation coming down at the very beginning is clearly to do with factors other than our policy. And those would include potentially supply chains getting a little bit better…What we’re looking for is month by month inflation coming down.’
• Despite 2022 growth getting downgraded to 2.8% from 4% in the December SEP and inflation slowing to 2.3% from 4.3% during 2022-24, the SEP shows unemployment remaining at 3.5% throughout. This unrealistic macro scenario suggests the Fed is reluctant to acknowledge the cost of lowering inflation. In turn, this cast doubts on its willingness to tighten once growth slows.
• Today’s SEP shows the Fed remaining behind the curve, with the SEP implied real FFR falling by 40bp and the gap between FFR and Taylor rule rate narrowing by only 40bp relative to the December SEP (Chart 1).

A 2023 Hard Landing Is More Likely After the FOMC

In my FOMC preview, I had sketched out two scenarios: tighten proactively and less or tighten reactively and more. I attached a risk of stepped-up tightening and a hard landing in 2023 to the second scenario. The policy gradualism the Fed showed today suggests we are more likely to be in the second than the first scenario.

The improvements in supply bottlenecks the Fed is expecting are unlikely to materialize. This is not only because of the Ukraine crisis but also because of the resurgence of Covid in China. In response to an increase in cases, China has implemented a series of lockdowns. China remains highly exposed to Covid since its zero-Covid policy implies it has low collective immunity.

Against these continued negative supply shocks, the ongoing US demand slowdown may be too slow to reduce resource pressures. The Fed’s SEP expects unemployment to remain below the long-term estimate throughout the projection period. Consequently, MoM inflation may not slow down as the Fed expects. It could even accelerate if, as I expect, the Ukraine crisis leads to an oil shock. Eventually, the Fed may have no choice but to tighten more aggressively, starting around late 2022. That could lead to a hard landing in 2023.

Market Consequences

Market pricing for 2022 is equal to the 2022 dot but 60bp below the 2023 dot. I expect the Fed to accelerate tightening in late 2022 and 2023, and the market is therefore underpricing the end-2022 and end-2023 FFR.