The Fed Has Fallen into a Time Inconsistency Trap, Can it Recover?

Summary

• The Fed could be overconfident on its growth and inflation outlook.
• Most importantly, the Fed has fallen into the time inconsistency trap of central banks trying to raise inflation expectations, which has undermined its credibility.
• The Fed has now set forth precedent on the inflation side of their reaction function that they may not have intended. And if they did, it conveys a pretty strong message that FAIT is not as expansive as it was sold to be at Jackson Hole last year.

Market Implications

• In a world of now, falling breakevens and flatter yield curves, tech should outperform cyclicals.
• The Fed has now added credence to the peak everything narrative, especially as this hawkish turn was already in the context of a growth declaration.
• Lastly, the Fed has now given the market more scope to price positive term premium. We think the market will lean into that more now given the asymmetry.

The Fed May Have Become Overconfident

The June FOMC meeting turned out more hawkish than we expected, which reflects both a change in the Fed economic assessment and its reaction function. In the presser, Chair Powell was very confident on the prospects for a strong recovery. He repeated many times that ‘we are on a path to a very strong labor market’.

In addition, the FOMC has become more concerned by the risk of de-anchoring of inflation mainly due to the high April and May inflation prints. Chair Powell repeatedly implied that the Fed would not hesitate to tighten policy if inflation expectations de-anchored. Finally, he conveyed greater confidence that the Fed can lift inflation: ‘I have more confidence that we could see inflation above 2 percent, that it may not be as hard to do that as we thought, and that inflation expectations may move up’.

Needless to say, we do not share Chair Powell’s sanguine growth outlook and inflation concerns. As government transfers to households are set to end by September, inflation pressures are likely to ease. In addition, wage growth is unlikely to be strong enough to make up for the decline in transfers and higher inflation. Growth could therefore slow over the remainder of 2021.

And of course, the LT factors that have held back inflation have not been weakened by the pandemic.

Fed Policy Has Become Time Inconsistent

The presser exposed a number of inconsistencies in the Fed framework. First, the FOMC has changed its mind on inflation expectations. Second, it is not clear if the FOMC lifted the 2023 dots because it no longer believes that the recent high inflation prints are transitory. The SEP shows core 2022 and 2023 inflation only 10bp above the Mar SEP.

What seems to have happened is the classic central bank time inconsistency, first highlighted by Krugman in 1998 in the context of the BoJ. In order to raise inflation expectations, a central bank needs to convince the market that it will act irresponsibly, in an un-central-bank like way. But once inflation expectations and inflation have reached the desired levels, the central bank has every incentive to renege on its promise to stay irresponsible.

The Fed has reneged so early in the process of raising inflation expectations that the recent increase in inflation expectations and inflation likely will not be sustainable. In addition, the Fed credibility to be irresponsible has been undermined which suggests that the next attempt at raising inflation will be more difficult.

Market Consequences: FAIT, Not Dead, But Wounded

The 2023 rate dot was the market’s litmus test for FAIT. You say that you want to delink the growth outlook from policy in a way that allows the economy to pro-cyclically expand the stance of policy, ok, show me in the dots. That was kind of busted this week. This changes the calculus for the market doing the pro-cyclical trade, at least in the short term. Good data being a steepener in a positive output gap world, is now dead. Can it return, yes, but not right now.

The moves in the dots were also hawkish in these ways:

1. First, the dots really contradicted the Fed’s idea of inflation being transitory, and that was echoed by a lack of that language in press conference.
2. Second, the bar has now been set for the dots to move again and it is asymmetric: what happens when 2022 growth is revised higher?
3. Third, the Fed effectively told us what a modest overshoot of inflation is, and it is not 2.5%, what many (including us) thought it was. Instead, it is 2.1%, which effectively means that ‘meaningful’ is now 2.5% and above.

Of course, it is possible that this is reading too much into 13 people who are not the marginal price setters at the board. But in a market sense, this will have to be digested. It can be fixed, but the balance of risks of the ‘hawkish’ – ‘dovish’ scale has been moved based on these dots.

The other fairly hawkish takeaway was actually from the presser on the labour market. Powell basically told us that ‘substantial further progress’ is fait accompli. In a meeting where the theme was the bar to tightening was maybe a tad lower than we previously thought, this was just fuel to the fire.

And finally, to complete the hawkish trifecta, the statement’s language on transitory was unchanged. This of course could still change, but given the context of the dots, it is certainly looking like the confidence in transitory got relatively shakier.

Overall: FAIT was wounded this week. The Fed does not change my expectations of a big handoff from the peak everything narrative to higher forward growth, but it did delay that transition.

In terms of trades, we think this makes it tricky to be short USD. And the clear winner to us is tech. And second, there needs to be more positive term premium.