Monetary Policy & Inflation | US
Summary
• Against my expectations, the Fed was incrementally more hawkish at the January meeting today.
• My risk case of five hikes in 2022 is now my base case, starting with a 50bp hike at the March FOMC meeting.
• The Fed’s game plan of gradual policy normalization remains and is unlikely to change until end-year as Chair Jerome Powell expects H2 improvements in supply.
Market Implications
• Although I think money markets are underpricing 2022 hikes, a bond and equity rally is still possible as the economy could return to TINA after Q1.
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Summary
- Against my expectations, the Fed was incrementally more hawkish at the January meeting today.
- My risk case of five hikes in 2022 is now my base case, starting with a 50bp hike at the March FOMC meeting.
- The Fed’s game plan of gradual policy normalization remains and is unlikely to change until end-year as Chair Jerome Powell expects H2 improvements in supply.
Market Implications
- Although I think money markets are underpricing 2022 hikes, a bond and equity rally is still possible as the economy could return to TINA after Q1.
Five 2022 Hikes in the March SEP Is Likely
Contrary to my expectations, the Fed was incrementally more hawkish today. As I expected, it kept asset purchases on through March and announced a March liftoff. But against my expectations, it did not hint at a mid-year start to QT2. The overall tone was somewhat more hawkish than I expected.
My risk case of five hikes is consequently now my base case scenario. Also, I expect a 50bp hike at the March FOMC as the real Fed Funds rate (RFFR) currently at -5.5% is the lowest since the 1950s and would remain so even after a 50bp hike.
Furthermore, Chair Jerome Powell conveyed strong confidence in the outlook: ‘Fortunately, health experts expect that cases will drop off rapidly. If the wave passes quickly, the economic effects should as well, and we would see a return to strong growth’. Also, he stated that ‘The labor market is very, very strong right now and I think that strength will continue.’
Five hikes seem to be about right:
- Powell did not push back against market pricing of Fed hikes, four before the meeting and 4.5 afterwards: ‘our communication channel with the markets is working’.
- Powell indicated that ‘since the December meeting I would say that the inflation situation is about the same but probably slightly worse. I’d be inclined to raise my own estimate of 2022 core PCE inflation, let’s go with that by a few tenths today.’
Meanwhile, unemployment is at 3.9%. That is already below the Fed’s long-run estimates of 4%. As such, FOMC participants in their March Summary of Economic Projections (SEP) submission will likely accompany an upward revision of 2022 inflation with an upward revision to the 2022 Fed Funds rate (Table 1).
Powell Protected Policy Optionality
Meanwhile, Powell did not convey a fundamental change to the Fed’s long-term game plan, namely a return to an RFFR of 0% over three years. We must place today’s hawkish comments in the context of policy normalization. As Powell stated today, ‘In light of the remarkable progress we have seen in the labor market and inflation that is well above our 2% longer-run goal, the economy no longer needs sustained high levels of monetary policy support’.
Furthermore, while today Powell said that ‘inflation risks are still to the upside in the views of most FOMC participants’, this is no news. Most FOMC participants have seen inflation risks tilted to the upside since the June 2021 SEP.
In this context, Powell did not signal a radically faster pace of normalization. Rather, he avoided providing details on policy normalization that would have reduced policy optionality. For instance:
- ‘It is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate.’
- ‘We know that the economy is in a very different place than it was when we began raising rates in 2015’. This statement was already mentioned in the December minutes and does not imply radically faster normalization than that currently priced in. In 2015, the Fed Funds was increased once, then not increased again for another year.
- ‘We are willing to move on the balance sheet sooner than we did the last time and also perhaps faster’. Again, this was already mentioned in the December minutes. It also tells us little, since 2015-17 saw a 2.5-year gap between liftoff and QT1, and we already know that this time quantitative tightening (QT) will start by end-2022. That is, within months of liftoff.
The risks of a change in the Fed’s long-term game plan are more likely at the end of 2022 if the supply improvements Powell expects in H2 have not materialized.
Meanwhile, Powell hinted at what could bring the Fed to slow policy normalization. Essentially, labour market slack (unemployment) would have to increase persistently against a backdrop of slowing inflation. I think the Fed will probably disregard a couple of bad Q1 payrolls as Omicron-linked and therefore transitory. Powell listed as negative factors or risks: fiscal policy, the pandemic getting worse, China’s zero-Covid policy, and Russia-linked geopolitical risks.
The Fed further provided its first formal statement on its strategy for balance sheet reduction. It repeated the message of the December minutes, namely that the Fed Funds remains the primary operational target and that QT would start after liftoff. It further indicated that the long-term balance sheet size would depend on the reserves required for the efficient functioning of its ample reserve framework and that it would mainly comprise Treasury securities.
Market Consequences
I see a risk of further curve flattening as the market is currently pricing 4.5 hikes against the five I now expect. Also, I believe the Fed is overestimating the strength of the labour market and see a risk that the unemployment rate could stabilize or even rise somewhat from current levels in H2.
That said, there is no sign yet the Fed is giving up on gradual policy normalization. In that sense, the equity market selloff seems unwarranted. A return to TINA after Q1, with the Fed fully priced in, mediocre growth, slowing inflation and limited headline macro risks, seems a plausible macro scenario.