FOMC Review: Stocks Will Slide on a Still-Slow Fed

Summary

• The Fed hiked interest rates by 75 basis points at yesterday’s FOMC meeting, as expected.
• More aggressive hiking will require overwhelming evidence that the current policy is failing, which will likely be unavailable until 2023.
• Meanwhile, the Fed is likely to follow the markets, which will guide it to an interest rate of about 3.8% by the end of 2022.

Market Implications

• Bonds and stocks to sell off.

What Happened at the Meeting?

As expected, the Fed hiked its main interest rate, the Fed Funds rate (FFR), by 75 basis points (bp). And in line with market pricing and my expectations, the Summary of Economic Projections (SEP) showed FOMC participants expect the FFR to be 3.4% by the end of 2022.   

Overall, the SEP was less hawkish than I expected. It showed the FFR increasing to 3.8% in 2023 then dropping back to 3.4% in 2024, against my expectations of 4.5% in 2023-24. The SEP also reveals expectations for unemployment. For 2024, these only increased by 10bp above long-term employment, which remained at 4%.

I think the SEP is unrealistic for two key reasons. First, the FFR projections are too dovish. They rely on disinflation to come from factors other than interest rate hikes – in other words, that macroeconomic imbalances will get resolved without policy intervention. This is unlikely because the imbalances are too large.

Second, the SEP shows almost no increase in unemployment. Yet such an increase is likely necessary to lower wage growth and inflation. With high inflation and very low unemployment, a wage-price spiral is giving inflation persistence. Breaking the spiral will require a much bigger increase in unemployment than the SEP showed, i.e., a hard landing.

The Post-Meeting Press Conference

A key indicator  the Fed uses to help determine how much it should hike rates is inflation expectations. If these de-anchor and start rising, it pressures the Fed to act more aggressively. Worryingly for the Fed, they have started de-anchoring (Chart 1).

At the press conference, Chair Jerome Powell downplayed the recent increase in inflation expectations. He stressed the Fed was concerned, but he did not admit expectations were de-anchoring. As he put it, ‘expectations are still in the place, very much in the place, where short-term inflation is going to be high but comes down sharply over the next couple of years.’ 

Powell did not explain how inflation expectations would drop. I am not a fan of inflation expectations. But the statements suggest the Fed lacks a clear strategy to deal with what, by its own standards, is a key risk to its inflation outlook.

What Will the Fed Do Next?

My biggest takeaway from the meeting is that the Fed is setting policy based on the most recent inflation readings. That Friday’s hot inflation print of 8.6% caused the Fed to break both its media blackout and March’s forward guidance of a 50bp hike for the June and July meetings is evidence of this.

What does that suggest for the next Fed moves? First, switching to a more aggressive policy necessary to control inflation is unlikely until evidence the current strategy is failing becomes overwhelming. This will require many data points, so the switch is unlikely until next year.

Meanwhile, I expect the Fed to continue to follow market pricing in its short-term decisions. Why? First, with high and persistent inflation, the Fed will lack the confidence to hike less than the market expects. Second, the Fed has been rudderless in its inflation strategy and therefore is likely to turn to the markets as a benchmark by default.

Powell indicated the July meeting hike would be either 50bp or 75bp. Markets are currently pricing about 66bp. And based on macro data showing continued strength, they are likely to show close to 75bp by the time of the meeting. So 75bp seems more likely.

What about the remainder of the year? My base case scenario is for 50bp hikes at each of the September, November and December meetings. This is because the data prints will likely remain strong. 

These rate hikes would come alongside gradual increases in the end-2022 FFR in the September and December SEPs. For instance, the end-2022 FFR could increase to about 3.6% in the September SEP and about 3.8% in the December SEP.

My risk case would be for one or more rate hikes of 75bp, for instance if inflation continues to accelerate and inflation expectations continue to de-anchor.

Market Consequences

Immediately following the meeting, the curve flattened, and risk rallied. Since then, the moves have reversed, suggesting the Fed strategy has lost credibility. I expect the loss of credibility to worsen, which is likely to see further curve steepening and risk selloff. We consequently remain underweight equities.