Why I Still Think the Fed Will Hit 8%

Summary

• The Federal Reserve’s (Fed) inflation game plan remains reactive and adds to the risk of falling further behind the curve.
• Market and economic data show the gap between the actual and Taylor rule federal funds rate (FFR) is still too wide.
• Breaking inflation inertia is likely to require a recession. That, in turn, requires a much higher FFR.

Market Implications

• Despite a recent increase in the terminal and December 2023 FFR, the market continues to greatly underprice the Fed.

Introduction

A year ago, I argued that the Fed would need to hike interest rates far higher than the market was expecting to stabilize inflation – to an 8% peak. Markets still doubt the Fed’s resolve to tighten, even after a year that included four jumbo 75bp hikes and a current FFR at 4.50-4.75%.

I gave three key reasons the Fed could get to 8%, and I think they remain valid today.

Reason #1. The Fed’s Inflation Game Plan Remains Weak

My first reason for the 8% call was the Fed’s inflation model, which I expected to underestimate the policy tightening needed to bring inflation back to the 2% target.

The Fed model, the expectations-augmented Phillips curve, predicted that, as long as inflation expectations remain anchored, supply shocks only have a transitory impact on inflation (2015 speech by then Chair Yellen). 

Today, the data continues to falsify this model: inflation expectations have remained stable, but actual inflation has soared (Chart 1).

After it became clear that high inflation was not ‘transitory’, the Fed moved to ‘data dependency’. The Fed has effectively given up on its former inflation framework, but has not adopted a new one.

Instead, it has decided to be reactive to the inflation data. Because of the lags involved in the transmission of monetary policy, this creates a risk that the Fed could fall further behind the curve. As a result, it may have to hike the policy rate by more than if it had taken a proactive approach.

Reason #2. Monetary Policy Is Still Too Loose

The second reason for the call was that the gap between the Taylor rule and the actual FFR was the largest since the 1970s. Fed tightening cycles typically start when the gap between Taylor rule and actual FFR is wide, and end when the gap has closed or greatly narrowed (Chart 2). 

By hiking 450bp since March 2022, the Fed has closed some, but not all, of the gap – that remains substantial. Monetary policy remains too loose, as shown by the data.

Growth is not slowing as the Fed expected, and this does not reflect policy transmission lags. 

Monetary policy changes have two speeds of transmission, fast and slow. Fast speed applies to policy transmission through financial markets, where the impact of policy announcements is instantaneous. For instance, equity prices are down 15% since the Fed announced it would tighten policy, at end-2021. Similarly, 30-year mortgages rates have increased by 350bp over the same period.

Yet, as Charts 3 and 4 show, home prices are stabilizing, and household net worth, relative to income, remains well above pre-pandemic levels. This reflects two broad factors: the enormous scale of easing during the pandemic, as well as structural factors that have made the US more immune to monetary policy.

Monetary policy tightening gets transmitted more slowly outside of markets, mainly through its impact on borrowing costs. Most of the increase in the FFR has already been passed to households (Chart 5).

Yet household credit growth has continued apace (Chart 6). And households’ financial obligations ratio (debt service, rent, auto-lease payments, homeowners’ insurance and property tax payments relative to disposable personal income) is still below pre-pandemic levels (Chart 4).

In addition to the hangover from the pandemic stimulus and the structural factors mentioned above, the lack of bite of monetary policy tightening likely reflects expansionary fiscal policy.

By contrast with a year ago, when the budget deficit was falling fast, the deficit has been widening (Chart 7). The CBO estimates that it could reach 5.4% of GDP in FY2023 (that ends in September 2023). The last time the budget deficit was 5.4% of GDP was 10 years ago, when unemployment was close to 8%. Unemployment is currently 3.4%

Up to the mid-2010s, Fed tightening cycles were accompanied by fiscal consolidation or by relatively tight fiscal policy. By contrast, this time the Fed will have to work extra hard to offset the impact of very loose fiscal policy.

Reason #3. The Economy Remains Stuck in a High Inflation Regime

A year ago, I noted that inflation was high and had acquired inertia. BIS research published since then cast some light on the nature of inflation inertia in high and low inflation regimes.  Low inflation regimes are characterized by ‘rational inattention’, that is, economic agents tend to ignore inflation changes. As a result, price changes across different categories of goods and services tend to be uncorrelated, and inflation is self-stabilizing, as in the Fed’s expectations-augmented Phillips curve.

By contrast, in high inflation regimes, wage and price behaviors become impacted by actual inflation. High inflation becomes a coordinating device between workers and businesses.  That is, price inflation becomes high because wage inflation has become high and vice versa.  Prices across most categories become correlated and shocks, such as energy price increases, spill over into the whole economy.

In my view, we are still in a high inflation regime, despite the recent slowdown in core inflation and wages. First, since 2021 wages and inflation have remained closely correlated, as they were during the 1970s and 80s, the previous period of high inflation (Chart 8).

Second, energy prices and core inflation have also become correlated, similar to the 1970s and 80s. I believe the recent slowdown in core inflation reflects this correlation and the decline in energy prices. 

In theory, since workers care about real wages rather than about nominal wages and businesses care about margins relative to wages, rather than about prices, disinflation could be brought about through income policy. That is, workers and businesses could agree on a level of real wages and margins consistent with low inflation. Income policies were tried in a limited form in the US in the 1970s, but without much success.

In practice, this would be unfeasible in the current political climate. Rather, in the absence of explicit coordination between workers and businesses, a recession is needed to lower both workers and employers market power and wage and price demands. And the less credible the central bank, the deeper the required recession.

Bringing about a recession, in view of the immunity of the US economy to higher rates, and of the loose fiscal policy, is going to require a policy rate close to the Taylor rule.

Market Consequences – The Path to 8% FFR

Since the bumper January NFP, FOMC members have been hinting at an increase in the terminal FFR in the March SEP. This gradualism leaves the US exposed to inflationary shocks.

An oil price shock would see core inflation accelerate and lead the Fed to tighten policy sharply. For instance, a mid-year oil price rally to $120/barrel could see the Fed hike the policy rate by 50bp each at the September and November meetings and 75bp at the December meeting. The Fed could also publish a December SEP showing a terminal FFR close to 8%.

In the absence of a shock, inflation is likely to drift higher due to the inertia associated with a high inflation regime and too loose fiscal and monetary policy. In such an instance, the FFR would take longer to reach 8%, though the most likely scenario would be that at some point the US would get hit by an inflationary shock. 

The biggest risks to my view are negative demand or cost shocks, for instance, if fiscal policy turned contractionary, if households’ savings increased sharply or if oil prices fell sharply. The Fed not complying with its inflation mandate would only add to medium-term inflation risks and the depth of the recession required to lower inflation.

If my view turns out to be correct, even after the recent moves, the market is still greatly underpricing the Fed.

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 publishes the blog Macro Sis that discusses the drivers of macro returns.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)