FOMC Preview – Questions To Watch

Summary

• A $15bn monthly taper is a done deal.
• The statement will likely say inflation risks are now to the upside. 
• I expect Chair Powell to be comfortable with current market pricing of 2022 policy hikes but refrain from saying so explicitly to maintain policy optionality and avoid pre-empting the December dot plot.
• Instead, investors should look for comments around the trade-off between inflation and unemployment, the symmetry in risks to the taper, the recovery in labour force participation or less stress on ‘inclusive’ full employment.

Market Implications

• Flatter curve.

Statement: Inflation Risks Are to the Upside

On 3 November, the FOMC will likely announce a taper ending around mid-2022: $15bn monthly, split between $10bn bonds and $5bn MBS. Meanwhile, Chair Jerome Powell will probably repeat that taper requires less stringent economic conditions than liftoff, and that now is the time for the former but not latter. Paragraph six of the statement will be changed accordingly.

Powell will also likely say he expects inflation to be transitory and recede once supply bottlenecks diminish. However, I expect paragraph two in the statement to reference that inflation risks are now to the upside. The September minutes introduced this change of view, and FOMC public participants have echoed it since then (Clarida’s Very Hawkish Speech Confirms Abandonment of FAIT). Finally, the statement will probably characterize the recent growth as still robust despite the Q3 slowdown.

Powell Is Likely Comfortable with Current Pricing of Hikes

The taper is already fully discounted. For investors, the more important issue is whether Powell agrees with current market pricing of rate hikes, about 2.5 hikes by end-2022. I see Powell as likely to feel comfortable with current 2022 pricing because:

• In the September SEP, the median 2022 dot already priced one hike.
• Since then, the FOMC has turned more hawkish.
• Powell likely sees the increase in the Q3 ECI to 1.3% from 0.7% in Q2 as signalling an emerging wage-price spiral.
• Since the GFC, the Fed has turned more hawkish. A persistent excess of actual unemployment over estimates of natural unemployment and inflation shortfalls relative to target show this (Chart 1).

Meanwhile, Powell will likely avoid providing a specific view on the Fed Funds 2022 trajectory to maintain full policy optionality and avoid pre-empting the December SEP. So we will have to infer his views from his tone and answers on issues such as:

• Trade-off between inflation and unemployment: at the September presser, Powell said that if faced with both high unemployment and inflation, the FOMC ‘would take into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with the mandate.’ He added that the current combination of high unemployment and high inflation was ‘temporary’. Powell could convey greater hawkishness this time by stressing inflation more.
• Hiking before taper is over: at the September presser, Powell said a faster taper was more likely than liftoff before the end of taper. I expect him to stress that the risks to the pace of taper are symmetric, i.e., faster as well as slower.
• Recovery of labour force participation: at the September meeting, Powell said the Delta variant of Covid-19 had delayed the recovery in participation. The wave of Delta infections seems over, and continued expectations by Powell of a limited increase in participation would be hawkish.
• Inclusive definition of full employment: at the September meeting, Powell essentially said it was no longer a priority: ‘I think eliminating inequality and racial discrimination and racial disparities and that kind of thing is really something that fiscal policy and other policies—frankly, education policies and that kind of thing—are better at focusing on.’ (The shift was also in response to criticism from Senator Pat Toomey.) I expect no change at this meeting.
• De-anchoring of expectations: Powell will also likely discuss the risks of de-anchoring of expectations. However, the Fed index of common expectations has increased by 1bp in Q3 relative to Q2, and the October University of Michigan 5-10-years-ahead inflation expectation has fallen 10bp relative to September (Chart 2). So Powell stressing risks to expectations would also convey hawkishness.

Market Consequences

Monetary policy potency is asymmetric. As former BoE governor Mervyn King explained, it can no longer do much to reflate the economy; on the other end, in a highly financialized economy with high and rising corporate leverage, monetary tightening can seriously damage growth. The Fed pulling the trigger mid-year on an already slowing economy would likely tip it into recession. My expectations of a hawkish FOMC meeting therefore imply a flatter curve.

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.)