On Monday, January 8, as per custom, nine economic departments submitted their respective estimates for China’s Q4 and full year 2021 GDP growth rates to the State Council before the release of the official figures this Sunday by the National Bureau of Statistics.
While these submissions don’t always translate into the final NBS figures, Monday’s estimates ranged between 7.9% and 8.2% for the full year 2021 GDP, clustered close to market expectations of about 8.0%. The Q4 2021 estimates ranged between 3.8% and 4.2%, also close to market expectations, but a bit higher than the 3.3% consensus published on Bloomberg that seems a bit of an outlier on the downside.
Officials in Beijing maintain that China’s economy remains “on solid ground” going into the new year, with many still expressing confidence that the economy will grow by more than 5.0% in 2022. That, at least, is the plan.

Bottom Line: Right now, there is nothing in the data that is stopping policy speculation from moving in a hawkish direction. Moreover, Fed speakers aren’t getting in the way of market participants moving in that direction. That does leave us a little nervous about some kind of pushback from Fed officials, but we see additional hawkish surprises as still more likely in that the Fed will add a fourth rate hike to the March SEP and the risks are rising that the Fed will need to come out of the gate with a 50bp hike.

On Ending QE

Importantly, the Fed still has time to change the narrative before the blackout period. Given that the Fed will be discussing QT, it would be reasonable that ending QE immediately would also be discussed at the January FOMC meeting.

In the near term, the Fed will be raising interest rates and initiating quantitative tightening. I continue to see chatter to the effect that the Fed is only talking hawkish so they don’t actually have to tighten policy. This is wrong. A March hike is basically a slam dunk and the only reason we can’t price it at 100% is the residual probability that something goes sideways over the next two months. Not only is a rate hike imminent, but quantitative tightening is soon to follow. Even former arch-dove San Francisco President Mary Daly agrees, via Bloomberg:
“I would prefer to adjust the policy rate gradually and move into balance-sheet reductions earlier than we did in the last cycle,” she said in a virtual panel discussion at the Allied Social Science Associations conference Friday. “I would not prefer to do it simultaneously,” she said, adding “you could imagine adjusting the balance sheet” after “one or two hikes.”
Most likely, the data is not going to influence this path in a dovish direction. The primary risk is that the Fed adds a fourth rate hike to the March SEP. That’s the direction the data is moving.

Altogether, this conversation indicates the Fed is considering going sooner, faster, and further with QT than in the last cycle. This makes sense if the Fed thinks it needs to unwind the balance sheet to open space to move in the next cycle. That said, it is odd (crazy?) that the Fed is having this discussion about needing to raise rates and initiate QT while it is still engaged in QE. And the fact that we are having this discussion while still buying asset suggests to me that the Fed is gearing up to begin QT soon. The deeper the Fed keeps going at this point – when there is no need for asset purchases and hasn’t been for quite some time – means it is going to have to get out sooner. I still like the idea of QT at the June meeting and rate hikes at the March, September, and December meetings with the risk of adding a rate hike in June and moving QT to May or July.

Monetary policy in 2022 will be “prudent, flexible, and appropriate and give full play to both the aggregate and structural functions of monetary policy tools.”

The PBoC will become more proactive in bumping up support for the real economy. Monetary policy will be targeted to further beef up support for high-tech, small, and micro businesses, green development, and other key areas and weak links of the economy.

On the aggregate side, the PBoC will leverage multiple tools to keep liquidity reasonably ample, “strengthen the stability” of credit growth, and reduce the financing costs of enterprises while keeping it all at “an overall stable” level. The PBoC will also actively ramp up structural policy support.

Beijing’s aim is for new loans to reach about 20 trillion yuan in 2022. Officials continue to support expectations that the bank reserve ratio will be cut by another 0.5 percentage points in Q1, and if truly needed, the PBoC will not rule out lowering the one-year loan prime rate (LPR) rate in the next few months.

Our baseline is and has been that the Fed begins rate hikes in March. Persistent inflationary pressures in the context of a tight labor market pushed the Fed to accelerate its tapering plans and open up room to pull its first rate hike forward. And the signaling since has if anything confirmed our expectations. Coming out of the December FOMC meeting, Federal Reserve Chair Jerome Powell clearly said the Fed did not need space between the end of asset purchases and the beginning of rate hikes, implicitly putting March on the table. Federal Reserve Governor Christopher Waller explicitly stated that March was a “very likely outcome.” Realistically, the signaling is clear; the only thing standing in the way of a rate hike in March is Omicron.
Our baseline is three rate hikes in 2022 plus quantitative tightening. The Fed penciled in three rate hikes for 2022 in the December SEP. While it seems like the Fed should expect four rate hikes if it anticipates a March hike, I think it expects that one quarter will be used for scaling back the size of the balance sheet. Such quantitative tightening (QT) would reduce the number of rate hikes needed to stem inflationary pressures. Waller suggested that QT should begin by this summer. That suggests a possible timeline of rate hikes in March, September, and December, with QT in June.
The risks tilt toward four hikes in 2022. The Fed’s December SEP projections of 2.7% core inflation and 3.5% unemployment at the end of 2022 appear to be an attempt to finally get ahead of the inflation story. If inflation does not decelerate as expected, the Fed will feel under pressure to add a fourth rate hike. Given the expectation that inflation remains elevated in the near term, the Fed would likely not recognize this until the middle of the year. To be sure, there is a risk that the Fed needs to pull back on its rate hike expectations, but I think that outcome would be more likely if demand were to suffer such that unemployment unexpectedly began to rise. That said, there doesn’t appear to be a big risk of that outcome now. Either way, the situation will evolve as the data rolls in over the course of the year.

Monetary Policy
On the monetary front, the stimulus will likely come in two phases. From when the most recent Reserve Requirement Ratio cut takes effect on December 15 to the Spring Festival on February 1, there will be an injection of more liquidity into the markets through the ramping up of re-lending to banks, including through a recently introduced decarbonization supportive tool. Another RRR cut will probably come then in February, although some officials think an interest rate cut may be less likely.
For perspective on magnitude and the room for stimulus, the CEWC meeting set the CPI target for 2022 at 3.0%, the same as for 2021, but predicted inflation would rise in a more modest way, from 0.9% in 2021 to 2.2% in 2022. And so, officials believe inflation will pose no major constraints on monetary policy.
Credit Policy
On the credit front, the CEWC pledged to stabilize credit growth, keeping total social financing growth broadly in line with nominal GDP growth.
That means next year’s credit target will be basically the same as this year, or slightly increased. That too will be front loaded — new loans are expected to reach about 20 trillion yuan in 2022, with the first quarter likely to be close to 8 trillion yuan, up about 300 billion yuan from 7.7 trillion over the same period last year.

It is increasingly recognized that Covid isn’t going away and consequently the focus needs to shift from cases to outcomes. President Biden ran on a campaign of bringing back “normality” and that isn’t going to happen with a nonstop media focus on the number of cases regardless of the degree of severity. The narrative must change, and I suspect will be changing in such a way that further lessens the negative domestic economic impact of the repeated waves of Covid. From what we are seeing now, the lack of vaccine durability, the potential for vaccine-evading variants, both of which mean ongoing breakthrough infections and create the need for a never-ending vaccination campaign, and the unwillingness of a percentage of the population to be vaccinated, suggests the administration will always appear to be fumbling the ball until it develops a strategy that acknowledges those factors and Covid as an endemic disease.

On The Dots
You ask, I answer, now with some quick thoughts on next week’s dot plot.
The theme for the week is my expectation of a high probability that the Fed hikes rates in March. My view is that the balance of risks is changing rapidly, as evidenced by the Fed’s sharp pivot from patience to accelerating the pace of tapering, that March must be considered in play. To be sure, we have three months of data before we get there, so anything can happen, but the data and the Fed narrative shift are driving us in that direction.

Additional Thoughts on the Fed Pivot

Last night at dinner I gave my daughter the choice of either reviewing the latest issue of Fine Woodworking magazine or working through the SEP projections and re-watching Powell’s press conference. She chose the latter (kids these days, right?). Between that review, questions from clients overnight, and some other chatter that has crossed my desk, I have some additional thoughts on the results of the FOMC meeting.

Last night’s note had a short-term focus, primarily on the timing of the first rate hike. I think Powell set the stage for a March hike. The bar for a hike is pretty low at this point, just getting the Fed to reach consensus on full employment. That might sound like a big hurdle but note how many times Powell emphasized “rapid progress toward maximum employment.” We are not talking about “ground to cover” anymore. And, critically, note the absence of this line from the November press conference:

"The unemployment rate was 4.8 percent in September. This figure understates the shortfall in employment,
particularly as participation in the labor market remains subdued."

That second line isn’t in the December press conference. Why not? There is no hidden unemployment anymore now that the Fed views labor force participation as a lagging indicator. The unemployment rate is now taken at face value and the current 4.2% is just a hair over the Fed’s longer run projection of 4%. The Fed can and will dress up the full employment story with all sorts of labor market indicators, but the short version is that the economy is right on top of it already.

The Fed has plenty of time to telegraph a March rate hike. The January statement can clear the way for a rate hike and declare full employment or an expectation to meet full employment by March barring an Omicron disaster. In addition, we will have the Humphery-Hawkins testimony and even Powell’s confirmation hearings to bring everyone up to speed. Plenty of opportunities to get the word out. Powell made clear that tapering would be complete by the time of the March meeting, and any time after asset purchases end the Fed can hike. And this from Powell is about as close as he can get to autopilot without outright saying “March”:

"…so we've been calling out the fact that those were becoming longer and more persistent and larger and now
we're in a position where we're ending our taper within the next, well, by March, in two meetings and we'll be in a
position to raise interest rates as and when we think it's appropriate and we will, to the extent that's appropriate."

Because of Omicron, the debate is March versus May. If Omicron wasn’t a concern, then it would be March. And Omicron might not warrant any delay at all – see today’s move by the Bank of England.

Importantly, note that the Fed has repeatedly surprised on the hawkish side since June, so a March hike absolutely must be in play. The June dots, pulling forward the taper into 2021, the September dots, the September validation of a November taper, the acceleration of the taper, the December dots, and I think Powell all-but-validated a March hike yesterday, which I didn’t expect. Simply put, I have been on the hawkish leading edge of the curve for months and yet the Fed has still been a notch ahead of me. And, to Powell’s credit, that hawkish evolution has been accepted by the markets without disruption.

I expect the Fed will begin unwinding the balance sheet soon after rate hikes commence. That said, the Fed has just begun to struggle with this topic. Back to Powell:

"So, you know, with the balance sheet, we did have a balance sheet discussion as sort of a first discussion of
balance sheet issues today at our meeting this week. We'll have another at the next meeting and another at the
meeting after that, I suspect. These are interesting issues to discuss. Didn't make any decisions today. We
looked back at what happened in the last cycle and people thought that was interesting and informative, and
but to one degree or another people noted that this is just a different situation, and those differences should
inform the decisions we make about the balance sheet this time so haven't made any decisions at all about
when runoff would start but we'll be continuing to, in relation to when either liftoff happens or the end of the
taper but those are exactly the situations we'll be turning to in coming meetings."

The first key takeaway in that paragraph is that the last cycle is at best only a rough guide to how the Fed will manage the balance sheet this cycle. The second key takeaway is that the Fed will be considering options in the next few meetings (end of taper or liftoff). The primary difference between this cycle and the last is the strength of the rebound. As such, the Fed isn’t going to wait nearly two years after the first rate hike before it begins reducing the balance sheet. More likely is that it will happen soon after the first rate hike, within 6 months at the most. Arguably, that comparison with the last cycle also argues for a faster unwind as well.

Finally, thinking about how this year evolves, have we reached “peak hawkishness?” I think the key is the 2.7% core inflation forecast for 2022. That feels to me like the Fed is trying to get ahead of the inflation numbers after being behind all year. In other words, the Fed might think that between that forecast and the three rate hikes, it won’t have to get more hawkish in 2022. But why not just go all the way and predict four hikes if there is a high likelihood the Fed will go in March? First, going from zero to four hikes when the market anticipates two would risk sending a message that the Fed was so far behind the curve it needed to shift to a restrictive policy more quickly. Second, three hikes leaves open the possibility of using one quarter to initiate quantitative tightening (this would follow the 2017 playbook), so they already have four policy moves in mind for 2022. That leaves open the possibility of a March rate hike yet still holding the 2022 dots at three.

For the Fed to get more hawkish early in the year, we should be looking for signs that the inflation forecast is already in jeopardy. Remember, there is a widely held expectation that the Fed will get helped by the base effects pulling inflation lower after the first quarter. I would be cautious here as the Fed should look through the base effects to the monthly numbers; the Fed should clarify this distinction. The Fed could be waiting for that inflation decline before becoming more hawkish. So, my advice is to watch the month-over-month inflation numbers. The second thing to be watching is wages. The Fed is betting that wage pressures don’t intensify (note that Powell talked about wages as a signal of tightness in the labor market). That’s an obvious implication of the sustained 3.5% unemployment forecast starting next year in the context of declining inflation throughout the forecast horizon. If wage pressures become more obvious or it looks like unemployment will be sinking below 3.5% by the end of the year, the Fed will turn more hawkish. Third, of course, is watching measures of long-term inflation expectations.

That’s all for today. A lot to process after a busy week.

European Union leaders agreed today, Thursday, to issue a strong joint warning to Russia to not invade Ukraine, or face “crippling new economic sanctions,” while calling on Moscow to come to the negotiating table.

The EU will keep the list of possible new sanctions undisclosed for now to keep Russia’s President Vladimir Putin guessing, but some ideas have already been floated in off-the -record, informal conversations with EU officials involved in the preparation of the retaliation measures. One might even think they are being deliberately leaked with no fingerprints, but what do we know.

To start, in their summit conclusions, the 27 European leaders will say, "Any further military aggression against Ukraine will have massive consequences and severe cost in response," according to a draft of the statement.

That is a clear copy-paste of the same sentence in the statement of G7 foreign ministers that was issued on Dec 12th, which came after Moscow had amassed more than 100,000 troops on its border with Ukraine and Washington had briefed European capitals that an invasion of Ukraine was possible in January.

Officials say that if Russia decides to test the resolve of the West over Ukraine, the EU will adopt an "escalation ladder" approach, depending on what action Russia undertakes. It would be coordinated with the U.S., Britain, and Canada.