FOMC Preview – The Fed Post Transitory

Much has changed since the Federal Reserve last met at the beginning of November. Since that meeting, when it announced it would start tapering quantitative easing, the Fed’s tone has changed. Now, policy will begin to follow.

The Fed’s Big Pivot Since the November FOMC

Five key figures have publicly said the Fed may need to accelerate taper at the next (this week’s) meeting. These are Chair Jerome Powell, Vice Chair Richard Clarida, Governor Christopher Waller, Cleveland President Loretta Mester and Atlanta President Raphael Bostic.

‘The economy is very strong and inflationary pressures are high, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases, which we actually announced at the November meeting, perhaps a few months sooner.’ – Powell

‘I’ll be looking closely at the data that we get between now and the December meeting, and it may well be appropriate at that meeting to have a discussion about increasing the pace’ of the pullback in asset buying. – Clarida

‘For my part, the rapid improvement in the labor market and the deteriorating inflation data have pushed me towards favoring a faster pace of tapering and a more rapid removal of accommodation in 2022.’ – Waller

‘I’m very open to considering a faster pace of tapering…Making the taper faster is definitely buying insurance and optionality so that if inflation doesn’t move back down significantly next year we’re in a position to be able hike if we have to.’ – Mester

‘The data, as it has come in over the last several months, suggests that we might, it may be appropriate for us to pull forward a liftoff…And if that’s true, then I think we need to have that optionality by getting the taper taken care of, and finished sooner rather than later.’ – Bostic

More dovish members of the FOMC, such as San Francisco President Mary Daly, have stated it could be appropriate for the Fed to raise interest rates next year. Daly said at a Peterson Institute webinar with Richmond President Thomas Barkin that the Fed may need to start crafting a plan for rate increases next year. She also said the December dot plot would likely show more than one interest rate hike in 2022.

At the White House press conference in which she was introduced as the new vice chair of the FOMC, Lael Brainard did not start with addressing shortfalls in employment. Rather, she started with inflation: ‘This means getting inflation down at a time when people are focused on their jobs and how far their paychecks will go.’

The FOMC’s tone has shifted concertedly since the November meeting. And an accelerated taper was how the Fed communicated that shift. An accelerated taper is effectively a way for the Fed to advance rate hikes without explicitly saying it. But the FOMC’s message since November is that they want more optionality in terms of rate hikes next year, and finishing the taper earlier than expected achieves that.

Powell’s Testimony

Powell’s 30 November / 1 December testimony had three big points that really hammered home the FOMC’s shift since the November meeting. This is, of course, outside just his rhetoric on an accelerated taper.

1. Responding to Senator Pat Toomey’s question on whether inflation is still transitory, Powell said, ‘I think it’s probably a good time to retire that word.’
2. Powell said that price stability is crucial for maximum employment goals: ‘To get back to the kind of great labor market we had before the pandemic, we’re going to need…price stability.’ Further, Powell said, ‘And in a sense, the risk of persistent high inflation is also a major risk to getting back to such a labor market.’ Powell, for the first time, said that the current level of inflation is a risk to the Fed’s labour market goals.
3. According to Powell, ‘The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation.’ While the policy statement continues to say that the Fed is operating in a broadly balanced risk world, implicitly, upside inflation risks now dominate the reaction function.

An implicit theme from Powell at his testimony was that the Fed will now pre-emptively fight further deterioration in its price stability mandate. This will replace being pre-emptive on the growth side.

In reaction function terms, upside risks to prices are greater than downside risks to employment.

The biggest takeaway from Powell’s testimony was that this was the first example where the Fed in theory could be in conflict (growth and inflation) through Omicron. And at least for now, they picked inflation.

What Will the December Meeting Bring?

The Fed has clearly pivoted over the past few weeks. The December FOMC will be the first time the Fed expresses that more officially. Expect the following.

For the dots, I look for the median to move to two hikes for 2022, three hikes in 2023 and four hikes in 2024. The maths simply cannot get the 2022 dot to show three hikes next year. The key dot to watch is the 2024 one, not the 2022 one. 2022 will struggle to show three given the composition. The question for the 2024 dot is, does it show policy at neutral or just below? This will be another sign of intent from the Fed.

The Fed will announce that taper will now conclude in March of 2022. This will theoretically give them the flexibility to hike rates as soon as Q2 or any time after the taper is officially complete. Notably, the March meeting is on the 16^th, so the Fed would have to wrap up the taper by then to make March live. That is not my base case, but would be unsurprised if the Fed wants to keep March live, especially as labour market data will also be hot in Q1.

On Powell’s tone, look for him to continue the theme of ‘hawkish optionality.’ Inflation is very high, so everything is on the table. Thinking about this shift, the Fed is moving from less dovish to slightly hawkish. The board’s pain threshold for these high prints has seemingly been hit.

My base case for next year is that the Fed hikes rates three times: in June, September, and December.

Jon Turek is author of the Cheap Convexity blog and CEO of JST Advisors.

(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.)