FOMC Review: Powell Leaves Door Open to More Hikes

Summary

• As I expected, the Federal Reserve (Fed) stayed on hold and Chair Jerome Powell’s forward guidance followed the blueprint of his latest speech.
• Tighter financial conditions could impact future rates decisions provided the tightening was lasting and higher bond yields reflected an increase in the term premium rather than in expectations of future rate hikes.
• Further rate hikes were a possibility if the data showed inflation was not on a sustainable path to the 2% target.
• Quantitative tightening (QT) would proceed apace as reserves were far from scarce.

Market Implications

• I still expect a December hike against the market pricing only 20% risk.

Fed to Observe Impact of Tighter Financial Conditions

The Fed signalled before the meeting that it would pause. As I expected, Powell’s latest speech provided the blueprint for the meeting’s forward guidance.

The Fed acknowledged tightening financial conditions in the statement by adding the word ‘financial’ in the sentence, ‘Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation.’

In the presser, Powell stated that tighter financial conditions ‘could matter for future rate decisions as long as two conditions are satisfied. The first is the tighter conditions would need to be persistent. And that is something that remains to be seen. The second is that the move up in longer-term can’t simply be a reflection of expected policy moves.’

That is, the increase in long-term yields had to be an increase in the term premium rather than in expectations over the policy path. Powell felt that the former seemed to apply.

Powell further stressed that the Fed was looking at a broad range of financial indicators and financial condition indices (FCIs). He did not mention the Fed’s own FCIs, which show that the bulk of financial conditions tightening is behind us.

Powell Leaves Door Open for Further Hikes

Powell stated that the FOMC was not confident yet that the policy stance was tight enough to put inflation on a sustainable path back to the 2% target. He stressed that a pause did not imply the Fed was done hiking and that the Fed had not moved away from the September SEP showing an additional 2023 hike. He also dismissed talk of rate cuts as premature.

Powell explained the unusual combination of disinflation and low unemployment as the unwinding of pandemic-related supply and demand distortions. Supply-side improvements included increased labour supply through higher participation and higher immigration as well as improved supply chains. However, he did not think that these alone would be enough to return inflation to target. In his view, demand compression through monetary tightening would also have to play a role.

Powell further stressed that there was a great deal of uncertainty surrounding policy transmission lags, potential growth, and R*. Rather than trying to get a precise estimate of what they might be, the Fed would look at economic data to decide whether further policy tightening was needed.

He stressed that inflation expectations were stable, despite the jump in the 1yr ahead of inflation expectations in the University of Michigan consumer survey.

He also stressed that the dot plot was a forecast not a commitment and that policy would be decided meeting-by-meeting, based on the totality of the incoming data.

As I expected, Powell stated that the FOMC ‘was not considering changing the pace of the balance sheet runoff.’ He further stated that reserves were far from scarce.

Market Consequences

Stocks and bonds rallied on expectations that Powell had indicated ending the tightening cycle, which I think is mistaken. I still expect a December hike based on inflation ending the year near the Summary of Economic Projections (SEP) forecast, on continued financial stability and growth remaining above trend. The recent move up in survey- and market-based inflation expectations supports my conviction. This contrasts with the market pricing only a 20% risk.

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.

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