Monetary Policy & Inflation | US
Summary
• I expect no more hawkishness this week than in December.
• Specifically, I expect the current taper schedule to remain unchanged, further hints of the first hike at the March FOMC meeting, and hints of quantitative tightening starting around mid-year.
Market Implications
• Both bonds and equities could rally.
• This is because, even though the meeting will be hawkish, it will weaken unwarranted concerns over a much more aggressive Fed and the uncertainty around Fed policy.
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Summary
- I expect no more hawkishness this week than in December.
- Specifically, I expect the current taper schedule to remain unchanged, further hints of the first hike at the March FOMC meeting, and hints of quantitative tightening starting around mid-year.
Market Implications
- Both bonds and equities could rally.
- This is because, even though the meeting will be hawkish, it will weaken unwarranted concerns over a much more aggressive Fed and the uncertainty around Fed policy.
Current Taper Schedule to Remain Unchanged
Since the December meeting, little has changed on growth and inflation. Growth has continued to slow, if faster since early January when Omicron’s impact strengthened, and the slow disinflation started in Q4 has continued (Chart 1). Consequently, the Fed’s stance has likely changed little since the December meeting.
I expect the Fed to maintain the current schedule of asset purchases, i.e., to end in March. Several investors have found the continuation of purchases inconsistent with hawkish talk and current hints at a March hike. I agree. But if I have learned one thing during my many years watching policymakers, it is that illogical policies can still see implementation.
And to be fair, there is an internal logic there. The 2020-21 Fed easing was unprecedented and open-ended, and it consequently acquired strong inertia (Chart 2). Meanwhile, as Chair Jerome Powell told us, the extent of supply bottlenecks and the persistence and high level of inflation surprised the Fed. After Q2 inflation accelerated, the Fed turned hawkish at the June meeting. But the Fed, having experienced the March 2020 and September 2019 volatility in the Treasury and money markets, felt unable to abruptly reverse course on asset purchases without risking renewed market volatility. Instead, it conducted its typical sequence: hints/announcements/implementation/acceleration. That took nine months. Partly to offset this, as Powell warned us, the taper/hike/quantitative tightening (QT) sequence will likely be much faster this time than in 2017-19.
I expect the taper to still end in March for two more reasons. First, the Fed is the Treasury’s investment banker, and a key tenet of the Treasury debt policy, and by association of quantitative easing (QE), is predictability. Second, the Fed wants to avoid looking rushed as that could imply it is behind the curve.
Inklings of a March Liftoff
A March liftoff would align with recent FOMC members’ chatter and the December Summary of Economic Projections (SEP). To justify a March liftoff, Powell will likely maintain a cheery outlook and dismiss the recent economic weaknesses as Omicron related and unlikely to last.
In all fairness to the Fed, the peak of the pandemic seems behind us (please see my latest calendar). Also, new medicines suggest much lower hospitalization rates ahead. Regardless, from the Omicron get-go, Powell has been more concerned by risks to the supply than demand side of the economy. That is, the Fed is more likely to hike more than to hike less in response to Omicron. I expect Powell will not resist a fourth hike this year, my base case scenario, and I see five hikes as more of a risk than three.
I base this on my inflation view. Despite improvements in supply, profits have remained high, reflecting strong corporate market power. Lower costs are fattening the bottom line of large corporations rather than getting passed on to consumers (Chart 3). This suggests only a gradual decline in inflation, unless the US economy experiences a demand contraction large enough to reduce firms’ market power. That is possible. After all, fiscal consolidation will be full-on this year while inflation is eroding household income, but more likely in H2. By contrast, H1 is likely to see an Omicron-related dip in Q1, followed by some recovery in Q2.
Hints of Midyear Start to Quantitative Tightening 2
For the second round of quantitative tightening (QT2), the Fed will likely follow its usual playbook. It will probably introduce policy tightening very gradually to avoid upsetting markets. Powell mentioned casually during the December presser that ‘we had our first discussion about the balance sheet, for example’ (the reporters present ignored him). The minutes then mentioned QT more formally, providing the broad contours:
- QT2, like QT1, will rely on reinvestment caps.
- QT2 will be implemented with more flexibility than QT1.
- Because inflation is higher, unemployment lower, the balance sheet larger, and average maturities lower than with QT1, QT2 would happen closer to lift-off and proceed faster than QT1.
I expect Powell to hint that QT2 could start around midyear, based on a recent statement that 2-4 discussions would be needed to finalize QT2 details. A recent article by The Wall Street Journal reporter Nick Timiraos, often an unofficial Fed voice, said ‘the turn from expanding the portfolio to contracting it is likely to be measured in months and not years’.
I also expect the Fed to start with low reinvestment caps, possibly as low as $20bn monthly to test market reaction. Then I expect it to accelerate based on economic and market development – in line with how it implemented the taper. Atlanta President Raphael Bostic’s expectation of $100bn monthly caps is possible, but more so in 2023 than 2022.
Powell will likely face questions during the presser on the trade-off and sequencing of hikes versus QT2. But I expect him to avoid specific answers as the FOMC is still finalizing QT2.
Market Consequences
Markets underestimated the Fed hawkishness after the December meeting. And as much as they did, they could now be overestimating it or, rather, overestimating its market impact. Markets are currently pricing four hikes in 2022, my base case scenario. But that is not an aggressive tightening plan: the real Fed Funds rate (RFFR) is currently -5.5%, the lowest since the 1960s. The end-2022 RFFR implied by the December SEP is -1.75%. Even if the Fed hiked five times in 2022, the end-2022 RFFR would still be below -1%. That is hardly the stuff of prolonged market selloffs (Chart 4).
The Fed timidity is inconsistent with its belief that monetary policy changes are transmitted to the real economy through changes in financial conditions. That is, a tighter policy stance requires weaker financial markets. The Fed is currently sitting on the fence, and I expect no more decisiveness at this week’s meeting.
Also, even if QT2 starts around midyear, as I expect, net government issuance net of Fed Treasury transactions is likely to be below 2021. Finally, banks’ reserves holdings are so large that this year QT is more likely to impact the reverse repo (RRP) than reserves.
These suggest the market selloff and curve tightening may not last. Also, while the meeting’s tone will likely remain hawkish, it could still assuage investors’ concerns over Fed hawkishness by providing further details on interest rates and balance sheet plans. Consequently, a rally in both bonds and stocks could follow the meeting.