FOMC Review: Three Parameters for Policy

Summary

• The Fed hiked 75bp, as expected.
• Powell announced a higher terminal rate in the December SEP and left open the possibility of another 75bp hike in December.

Market Implications

• The market is underpricing the December hike, the terminal FFR and the end-2023 FFR.
• Negative equities, further curve inversion.

Fed Frustrated by Lack of Progress on Inflation

As consensus and I expected, the Fed hiked the Federal Fund band 75bp to 3.75–4%. The economic assessment in the statement was identical to September.

During the presser, Chair Jerome Powell made it clear that the persistence of high inflation had disappointed the Federal Open Market Committee (FOMC).

He further stressed that the labour market ‘remained extremely tight’ with ‘unemployment at a 50-year low’. Wage growth was flattening out but ‘at a level well above what would be consistent with 2% inflation’. In general, the transmission of policy tightening to the real economy had been limited. This was partly due to households’ ‘strong balance sheets and built-up spending power’ that had offset fiscal headwinds.

Fed Acknowledges Policy Transmission Lags Are Unknown

The statement’s policy guidance section included a new sentence: ‘In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.’

However, during the presser, Powell also stressed that the extent of the lags was unknown. Policy, therefore, had to be based on risk management.

Powell believed the Fed could more easily correct over-tightening than under-tightening. ‘If we were to over-tighten, we could then use our tools strongly to support the economy.’ By contrast, under-tightening could see high inflation persist long enough for inflation expectations to be de-anchored, which would make inflation stabilization very costly in terms of employment losses.

When asked for the staff estimate of the underlying inflation rate, Powell declined to provide a specific number. This suggests that Powell does not have an inflation model he trusts, so policy is likely to remain driven by short-term data developments, especially in the labour market and inflation.

The Fed’s Three Policy Parameters

Powell made it clear that ‘It’s very premature in my view to be thinking about or talking about pausing our rate hikes. We have a way to go. We need ongoing rate hikes to get to that level of restrictive [policy]. We don’t know where that exactly is.’

He sees three parameters for policy:

1. How fast to go. He viewed the current pace of tightening as ‘fast but appropriate, given the low level from which we started’. At the same time, as policy ‘move[s] into more restrictive territory, it becomes appropriate to slow the pace of increases’. And the slower pace of hikes ‘may come as soon as the next meeting or the one after that. No decision has been made’. The discussion will take place at the next FOMC meeting.
2. The terminal rate. Powell announced a higher terminal rate in the December Summary of Economic Projections (SEP). Since the September meeting, ‘incoming data, both the strong labor market but particularly the CPI report, suggest to me that we may move to higher levels than we thought at the time of the September meeting.’ When asked if the real federal funds rate (FFR) would have to be positive, Powell indicated that he wanted borrowers to face real positive rates on a forward basis, for instance, based on inflation expectations. He had no guidance on when the terminal FFR would stop rising other than it was premature to discuss pausing.
3. How long to stay at a restrictive level. Powell did not elaborate, possibly because the terminal FFR is still a long way away. But the hawkish tone of the presser suggests the Fed could remain restrictive until it feels confident that inflation is heading down.

Market Consequences

Powell turned out more Volker than Burns yesterday. His economic views are becoming closer to mine. Therefore, based on current data trends, I am sticking to my expectations of a close to 8% terminal FFR. This would be negative for risk assets and imply further curve inversion.

Overall, Powell successfully introduced a forthcoming slowdown in the pace of rate increases without triggering a marked easing of financial conditions. Yet markets, in my view, continue to underprice hikes. Following the meeting, they are pricing about 50bp in December, which I think is inconsistent with inflation, labour market trends, and Powell’s resolve.