December FOMC Meeting Review – Goodbye Fed Put

Summary

• Liftoff at the March FOMC meeting is likely given the FOMC view that the US is near full employment, that YoY inflation must lower to avoid de-anchoring expectations, and that the taper will now end by March.
• Higher inflation or wage prints could see the Fed lift the dots further at the March meeting.
• The bar for lowering the dots is high and would likely require an economic contraction or a tightening of financial conditions that threatens financial stability.

Market Implications

• Negative risk assets: with high and persistent inflation, the Fed needs tighter financial conditions. The Fed put is gone or at the very least has repriced much lower.

A March Liftoff Is in Play

The December meeting marked a strong hawkish turn for the Fed. It doubled the taper pace to $30bn a month and will end it by March, raised the dots by more than I expected in 2023-24, and gave a hawkish presser. 

Before today, I expected liftoff in June. But I now give March a 55% chance for the following reasons:

1. The Fed has moved on from FAIT. Chair Jerome Powell stated, ‘This is not the inflation we were looking for under our framework at all. It’s nothing to do with our framework and the way we’ve approached it is really nothing to do with our framework.’
2. The Fed sees the US economy as near full employment. Powell stated, ‘the labor market is by so many measures hotter than it ever ran in the last expansion.’ And he listed as evidence the ratio of job openings to vacancies, quits, wage growth and the convergence between whites and minorities unemployment. He also noted the unemployment rate was only 20bp above the FOMC’s longer-run estimate of 4%. He further stressed, ‘the reality is, we don’t have a strong labor force participation recovery yet, and we may not have it for some time. At the same time we have to make policy now, and inflation is well above target.’ I can see unemployment at 4% by March, based on continued flat participation.
3. The Fed further confirmed it is targeting YoY headline inflation, which it expects to remain high through 2022. As Powell explained, ‘There’s a real risk now, that inflation may be more persistent and that may be putting inflation expectations under pressure, and that the risk of higher inflation becoming entrenched has increased’. Meanwhile, the end-2023 core PCE projected in the SEP at 2.7% is well above my estimate of the Fed’s ‘margin of tolerance’, which I believe is under 2.5%. I was surprised to see the Fed so open about the likelihood of high inflation persisting through 2022. An aggressive monetary policy will be needed to counteract this high number.
4. Powell sees Omicron as more negative for supply than demand.
5. The timespan between the end of taper and liftoff is likely to be much shorter this time. Powell said, ‘the last cycle had quite a long separation before interest rates (were raised), I don’t think that’s at all likely in this cycle. We’re in a very, very different place with high inflation, strong growth, a really strong economy.’

What Could Lift the Dots?

Powell explained the triggers for his hawkish pivot. These were the ECI print at 5.7% SAAR QoQ on 29 October, the strong October employment report, and the ‘very high’ November CPI. His explanation shows he is more responsive to short-term data development than to a medium-term, model-based view of inflation. Powell also said he believed monetary policy was transmitted to the economy through changes in financial conditions – and faster than the traditional 12-18 month lag argued by Milton Friedman.   

Powell’s comments suggest that a further acceleration in the ECI (next released on 28 January) or the CPI could see the FOMC lift the dots at the March meeting. Specifically, core PCE at 2.7% by end-2022 implies MoM prints of 22bp (that also happens to be the three-month average to November). Average MoM core PCE above 22bp could be a trigger.

I do not think continued flat participation would be enough to lift the dots. The FOMC is already basing its current inflation and full employment views on no progress in labour supply.

What Could Lower the Dots?

Since the Fed believes inflation will remain above target until past 2024, an economic slowdown would have to be pronounced to slow policy tightening. Powell explained that if inflation remained high before the economy reached full employment, the ‘balanced approach provision’ in the Fed framework would ‘enable us to, in this case, because of high inflation, move before achieving maximum employment.’ However, he did not expect to have to invoke the paragraph. So a suspension of Fed tightening could require negative growth.

So far, no evidence exists that Omicron is negatively impacting economic activity, though ICU utilization is rising (Chart 1). The biggest economic risk from Omicron is hospital capacity constraint, higher mortality of younger age groups or businesses pausing hiring or capex (Are Covid Vaccines Policy Placebos or Pandemic Shields?).

Also, with high and persistent inflation, the Fed is unlikely to be responsive to market weaknesses. In 2018 Q4, the Fed kept hiking despite equities weaknesses: at the low, the SPX hit 2350 – down 20% from its previous peak (Chart 2). Eventually, the Fed eased in July 2019, but only after core PCE fell to 1.6%.

This time, for a selloff to get the Fed to suspend policy tightening, it would have to threaten financial stability. For instance, it must threaten businesses’ access to funding or market functioning. A garden variety bear market alone would be unlikely to elicit Fed support.

Market Consequences

Stocks rallied after the meeting that, in a narrow sense, was fully priced in, with the dots only marginally above the corresponding money market rates.

I think the market is too complacent. Before the pandemic, markets had benefitted from a Fed put because the Fed believes monetary policy is transmitted through financial conditions and because inflation had been persistently below target. But this time, inflation is likely to be persistently above target, and the Fed needs tighter rather than looser financial conditions for monetary tightening to transmit to the economy. This suggests the Fed put is gone or at least has repriced much lower than implied by the market taking today’s FOMC meeting in stride.

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.

(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.)