...Asked and Answered

Final thoughts heading in the FOMC meeting, in Q&A format.

Why not just pull the trigger on a 100bp rate hike?

Great question, if you know you are still some distance from where you are going, why not just step up the pace? And wouldn’t a surprise hike be the best way to send a hawkish message? And doesn’t the Fed keep falling behind the curve, so isn’t this a chance to finally make some real progress on catching up to the curve? All these points are accurate, and it’s why we can’t say there is no risk of 100bp this week.

Perhaps the best argument for a 100bp is that this meeting mirrors the choices the Fed faced in November 1994 when then-Chair Alan Greenspan pushed the option of 75bp over 50bp to surprise on the hawkish side.

But Greenspan didn’t have the Summary of Economic Projections to bolster the Fed’s messaging with forward guidance. The communications structure is much more sophisticated now and will be unmitigatedly hawkish. So we still think the Fed opts for 75bp because it already passed on the bigger hike once in July, the last CPI number only tells us that inflation is not decelerating, and a number of FOMC participants were leaning toward 50bp ahead of Federal Reserve Chair Jerome Powell’s Jackson Hole speech which suggests it might be difficult to get a consensus on 100bp. A 100bp hike also aggravates the problem of the step down, the Fed doesn’t like to surprise the markets and induce additional volatility, it really doesn’t know where it’s going despite the SEP, and the Fed probably believes it needs some space to keep hiking until inflation softens...

...Will the Fed really raise the terminal rates 100bp in the SEP?

As we wrote this week, we think a sizeable increase in the terminal dot is the logical conclusion of normalizing 75bp rate hikes, but this is an aggressively hawkish view and would be a big lift for FOMC participants to pencil in. Repeating what we said yesterday, we think the risk for the dots is on the upside of the 50bp minimum increase in the terminal rate that we could expect. It’s probably too hawkish to expect more than a 75bp increase in the terminal rate even if anything less indicates the Fed anticipates the cycle is almost over...

...Will the Fed raise the estimate of the longer-run policy rate?

We heard this question frequently from clients last week. The general view, like we have written, is that the Fed’s estimate of the longer-run rate is an anchor on the long end of the yield curve, and rates can really move higher if the Fed was to cut ties with that anchor.

With the 10-year treasury yield now well above 2.5% and the economy still chugging along, there appears to be some reason to think an upward revision should be considered:



That said, we have yet to hear a Fed speaker say they are revising up their estimate of the long-run real neutral rate. I think the sense is that the factors that grind out an approximately 0.5% real neutral rate have not changed since the pandemic, and consequently it would be premature to raise the estimates.

In my opinion, the potential to raise this estimate is an upside risk for yields, but I am not seeing it just yet. We will keep shaking this tree. Personally, I would very much like to see what happens if they stopped trying to make this estimate...

...What is the terminal rate in this cycle?

I have no defined sense yet of the terminal rate, although I think the odds favor more than 5% and not less than 4.5%. Traditional rules say the Fed is still behind the curve. This is true with even generous interpretations of traditional rules. St. Louis Federal Reserve President James Bullard presented a minimalist Taylor rule in May, concluding the appropriate policy rate at the time was 3.63%. The same calculation now yields 4.5%. But this is an extremely generous rule. It assumes the real neutral rate is -0.5%, compared to the SEP estimate of 0.5%. Making that change alone pushes the appropriate policy rate to 5.5%, and that still might not be enough given that Bullard assigns no impact from unemployment lower than its natural rate. We could be a long, long way from the appropriate policy rate which means that policy remains accommodative and thus the lagged impact of policy is still stimulative. Let that sink in...

...Regardless of the dots, Powell will attempt to maintain a hawkish tone at this press conference. Now that we are past the peak recession story, and there is no convincing evidence of any sustained slowing of inflation, Powell should be free to take on a tone more like Sintra and Jackson Hole and less like the July press conference. I think Powell will want to follow Waller and emphasize the uncertainty about the path of policy:
I expect that getting inflation to fall meaningfully and persistently toward our 2 percent target will require increases in the target range for the federal funds rate until at least early next year. But don’t ask me about the policy path because I truly don’t know—it will depend on the data...

Fed on Path for Another 0.75-Point Interest-Rate Lift After Powell’s Inflation Pledge
Fed officials face questions over how high to lift rates by year’s end and how fast to get there
By Nick Timiraos
Updated Sept. 7, 2022 10:29 am ET
In a speech Aug. 26 in Jackson Hole, Wyo., Mr. Powell underscored the central bank’s commitment to boosting interest rates enough to lower inflation from 40-year highs. “We will keep at it until we are confident the job is done,” he said.
His remarks and tone placed him among the Fed officials who favor a more aggressive pace of rate increases than others, said Tim Duy, chief U.S. economist at research firm SGH Macro Advisors. Raising rates by 0.75 percentage point would fit that approach, he said.
Mr. Powell’s speech showed he “very much did not want to leave the impression that the Fed would fall short on fighting inflation,” Mr. Duy said.

Several officials have signaled a desire to raise the fed-funds rate closer to 4% by year’s end—or about 1.5 percentage point higher than its current level. That could be accomplished in rate increases of various sizes at each of the three remaining Fed meetings this year.
The hawkish approach would point to a 0.75-point rate rise at the coming meeting, followed by smaller increases at the next two, analysts said.
“The argument is you’re going to have to go much further than where policy rates are now, and the risk of overshooting is still fairly low,” said Mr. Duy. “And you would rather try to get a little bit more ahead of the curve rather than risk falling behind further.”

A 75bp move on September 7 to 3.25% would position the bank to calibrate the next phase of its policy cycle -– an enviable position that most other central banks have yet to achieve -– where it can begin to guide rates via smaller increments to a restrictive terminal rate that truly will be guided by incoming data.
Still chasing inflation but no longer chasing a neutral rates setting, the BOC then will deliberate whether it needs 50bp or 75bp in tightening over its two remaining meetings this year to finish 2022 around 3.75% or 4%.
With no accompanying press conference this week, the central bank may drop the “frontloading” reference in the statement once rates are at neutral. That change would denote the largest hikes are behind the BOC. Its July statement described the 100bp move as frontloading “the path to higher interest rates.”
We do, however, expect the bank to retain statement language indicating that rates will need to rise further, particularly given inflation still remains too high for Macklem to declare a stopping point.

The Reserve Bank of Australia (RBA) is likely to deliver its fourth consecutive 50bp rate hike this week, taking the cash rate to 2.35%, as it seeks to push rates into more restrictive territory to get inflation under control despite a torrent of protest over a housing market downturn.

...I think we can already see the points that represent the central messaging at this week’s upcoming Jackson Hole conference. I anticipate that sideline discussions will emphasize the hawkish points of agreement discussed above: rates need to be in restrictive territory and stay there for an extended period, restoration of price stability is the number one job, and don’t believe we won’t accomplish that goal. There is less unanimity here than it appears, at least as far as the terminal rate is concerned, and financial journalists can press to find divisions should they choose to do so, but that basic messaging should be uniform across speakers...


...Bottom Line
FOMC participants might share a common objective in restoring price stability, but with rates now in the range of long-term neutral, there is no consensus among members of the ultimate level of policy rates necessary to meet that objective. We think that the consensus will eventually emerge on the higher end of the estimates, but that remains to be seen. That said, there is a very unified theme in the messaging, and Powell can reinforce that theme. Market participants are hawked up going into this week, and that sets up the risk they will be disappointed by anything that feels less than a total repudiation of the July meeting and minutes. That said, I also get the sense the market participants would like to take on a solid, one direction trade as they return from summer breaks, and if they want to focus on the hawkish messaging, they can take short term rates higher.

With all the focus on rate hikes, there was one additional comment in today’s interview that did not get much coverage, but which we found intriguing. That was to float the possibility that the size of the ECB’s balance sheet and the reinvestment of the bonds held under the Asset Purchase Program may be a matter of discussion by the Governing Council soon.
We have, truth be told, assumed that reinvestments would be on autopilot for a while, so any material discussion, if it were to happen, would be newsworthy.

...Stimulus, as in the first half, will come largely from the fiscal side.

There, the CFEAC stressed that governments at all levels should continue to accelerate fiscal expenditure and shore up domestic consumption in the second half of 2022. It approved fiscal expenditures of 13.821 trillion yuan for the second half, an increase of 2.9% from the same period last year, and an increase of 7.2% from the 12.888 trillion yuan in H1 2022. It called for China’s fiscal expenditure to grow by double digits year over year in H2 to achieve Beijing’s full-year 2022 fiscal spending target of 8.4% growth.

The 12.888 trillion-yuan H1 fiscal expenditure figure represents a 5.9% increase from the same period in 2021 and makes up 48.25% of the 26.71 trillion yuan full-year 2022 fiscal spending target. China’s local governments, encouraged by Beijing, issued 3.41 trillion yuan worth of new special bonds in the first half of 2022, a 93% frontloading of the 3.65 trillion-yuan annual quota for new special bonds this year, and leaving little room for additional new issuance this year under the current quota.

To help steady economic growth from Q4 2022 to H1 2023, local governments will therefore pull issuance of new special bonds from the 2023 quota into October and November of this year. About 1.8 trillion yuan of special bonds are expected to be issued in advance...

Bottom Line: The CPI report is on net good news, but not good enough to deter the Fed from ongoing rate hikes. It leans the odds back toward 50bp at the next meeting, but not decisively so. While there is a heavy focus on the next meeting, this report alone doesn’t suggest we should expect a lower rate path even if the Fed opts for 50bp. That choice actually argues for a higher path of rates assuming elevated inflation remains persistent. If the Fed concludes that it can’t restore price stability without a recession, then 50bp would only be delaying the inevitable and 75bp becomes a more obvious option.

Now Bailey, concerned about so-called second round effects feeding into inflation, looks set to cross over to recommend 50bp, and with the support of at least his chief economist Huw Pill, that vote should carry the day. Both supported only 25bp in June.
MPC members are fretting that price and wage setting behavior could entrench inflation at a higher level. In the most recent comments by a BOE official on July 7, Pill noted that the BOE’s guidance reflects “a willingness – should circumstances require – to adopt a faster pace of tightening than we have seen implemented in this interest rate cycle so far.”
Three of the four external board members – Jonathan Haskel, Michael Saunders, and Catherine Mann – already wanted 50bp in June. Of the four remaining votes, at least one, if not two other members, might also vote for 50bp.
Even as the Bank most likely opts for the bigger increment tomorrow, it will be careful not to suggest a string of 50bp moves will follow, nor even that it won’t sit out moves later this year. Additional guidance Thursday will, however, shape expectations about how quickly the Bank intends to get to a neutral rate around 2.25%.

...Economic and trade sanctions are under consideration. Two measures will definitely be implemented. One, China will continue to reduce its holdings of US treasuries and other USD assets. The scale of the reduction must be larger than before. Two, China will strictly limit the export of rare resources such as rare earths to the US. To ensure that it is more difficult for the US to obtain scarce resources from China, the restriction would likely be extended to the UK, Japan, and Australia...

...Separately, from a hardline National Security official:
On the surface, Pelosi’s visit to Taiwan is a victory for the US, especially Pelosi. In essence, Pelosi’s visit has [however] broken the Cross-Strait status quo and created conditions for us to turn on a new status quo for the Taiwan situation. From now on, the PLA will more freely conduct military activities around the island. Without Pelosi’s visit, the status quo of the Taiwan Strait would not have been changed so quickly by the PLA...

...In the words of a leadership level official in Beijing:
Pelosi’s visit officially marks a shift in China-US relations from cooperation to all-round confrontation, and also marks the complete breaking of the status quo on both sides of the Taiwan Strait. Future US-China relations will continue to deteriorate.
The order not to directly block Pelosi’s plane from landing in Taiwan was made by President Xi himself [note – we believed this type of direct confrontation with the US was not likely to happen anyway]. President Xi said that Pelosi’s visit to Taiwan can clearly show the world that the US is directly provoking China’s core interests. It is the US and Taiwan separatist forces, not Mainland China, that first changed the status quo of the Taiwan Strait. When Pelosi arrived on the island it was the beginning of our definition of the new Taiwan Strait status quo...

Bottom Line: Expect more of this rhetoric from Fed speakers. The Fed remains committed to ongoing rate hikes until the inflation data rolls over for a sustained period. That basic messaging hasn’t changed even though the Fed looks forward to stepping down from 75bp rate hikes. It has simply been a challenge for the Fed to communicate its hawkish intentions when market participants have been looking for a dovish pivot. We expected this communications challenge, as well as a divergence between market pricing and the Fed’s intentions as economic growth eased. At some point, the Fed and markets will be realigned, and the data will decide whether the Fed needs to move to the markets or vice-versa. Today’s round of speakers indicates the Fed thinks the market will be the one that needs to move.

...Cleveland Federal Reserve President Loretta Mester will talk about the economy and policy. Mester has been a reliable standard-bearer for the Fed in recent months, and I expect her to push back on the market’s dovish interpretation of the FOMC meeting...

...Bottom Line

We always expected communication challenges around stepping down from 75bp. I think that much of the Fedspeak perceived as dovish reflects those challenges. The Fed is super-hawkish, but we went into last week saying that market participants would see any story around slowing growth as dovish even if couched in the hawkish story of rates continuing to rise until the Fed sees compelling evidence of a path to price stability. So far, that’s how this is playing out. Despite my caveats above, I still think the Fed is more hawkish than it appears, and more hawkish than implied by market pricing, and this creates the potential for a clash with the markets if the Fed stays resolute and inflation remains elevated as I expect.

That said, in the near term, market participants may continue to focus on the slow growth story until either they see evidence the economy is firming in Q3, something which if true is likely to take couple of months to emerge in the data, or the Fed starts walking back Powell’s performance and pushes the inflation story hard. I don’t think the Fed wants markets to take on a risk-on posture, and if so, we will see more pushback soon. Mester is the voice on the schedule this week that might make it stick. Still, I wonder if we will need to see this message come from the Board, and specifically from Powell. But this might now be an “actions speak louder than words” situation. I am thinking we should be wary about the Fed ditching this “no guidance” story and locking in 75bp for September. The risk certainly falls on that side of 50bp; even if the Fed is looking for an off-ramp to 50bp, it may have already lost the opportunity.

...The most important topic in the conversation was only one — China-US relations, especially the ‘Taiwan Question,’ which is the top priority of Sino-US relations. The topic of China-US relations accounted for more than 100 minutes of the 130-minute conversation.
President Xi told President Biden, “You always say that the China-US bilateral relationship needs a “guardrail.” Where is the bilateral guardrail now? The Three China-US Joint Communiqués are the most reliable guardrails for the two countries. Viewing China as the primary rival and the most serious long-term challenge would be misperceiving China-US relations and misreading China’s development. The US should keep its promise of not supporting Taiwan secessionism. If the US does not keep the China-US relations away from the edge but instead, insists on crashing against the guardrails, the consequence will be a deadly disaster.”
Regarding Pelosi’s possible visit to Taiwan, he continues, the President [Xi] said loudly and clearly that [the position of the] Chinese government and people on the Taiwan question is consistent, and resolutely safeguarding China’s national sovereignty and territorial integrity is the firm will of the more than 1.4 billion Chinese people. China firmly opposes separatist moves toward Taiwan independence and interference by external forces, including the US House Speaker’s visit to Taiwan, and never allows any room for Taiwan independence forces in whatever form. The will of the people cannot be defied, and those who play with fire will perish by it. If the US eventually lets its partisan struggle and internal politics hijack its strategic decision-making, it will surely bring new crises to the Taiwan Strait. It is hoped that the US will be clear-eyed about Taiwan.
Biden reiterated that the one-China policy of the US has not changed and will not change, and that the US does not support Taiwan independence but is opposed to unilateral changes to the status quo by either side. Biden stressed that he and his national security team have been and will continue to persuade Pelosi to abandon her visit to Taiwan.
In the conversation, Biden hoped to discuss the Ukraine crisis in depth with Xi. Xi declined to discuss it in depth but briefly stated China’s position.
This official believes the probability of Pelosi’s visit to Taiwan is low, as Xi’s tough position on Taiwan will push President Biden to put more pressure on Pelosi to bypass Taiwan on this trip. We are not so certain...

The Reserve Bank of Australia (RBA) will likely deliver the third in a series of 50bp moves in the cash rate to 1.85% August 2 and signal more tightening to come in the months ahead, tacking a more aggressive charge toward a restrictive policy setting beyond its 2.5% neutral estimate by year’s end...

...The pickup in the annual trimmed mean measure of core inflation, closely monitored by the Bank, could keep the prospect of at least one additional 50bp move at the September 6 or October 4 meetings alive, but probably not at both, at least not before the RBA sees another inflation report.
The next quarterly inflation reading is due October 26 and will give the Bank an opportunity to calibrate whether to move ahead with 25bp hikes at the November 1 and December 6 meetings...

I suspect that the Fed will be unhappy with the new market pricing and the implied easing of financial conditions, and we will see speakers push a hawkish story in coming days. Still, it may be hard to convince market participants that the Fed remains focused on inflation until the Fed hikes after the unemployment rate ticks higher. In other words, actions speak louder than words.

I believe that Federal Reserve Chair Jerome Powell is not likely to give hard guidance about the outcome of the September meeting but will keep 75bp on the table.

The last of the Fed’s 75bp rate hikes will be viewed by market participants as a “dovish” pivot. There will be a sense that the “worst of the cycle” has passed, and now we can look forward to the eventual rate cuts while downplaying the additional rate hikes between now and then. I suspect that a sense of relief will even be true among many FOMC participants who will believe the Fed is no longer deeply behind the curve on inflation, but they will have to be careful about how they express this relief...

...The Fed will not see the transition away from 75bp as a dovish pivot. The Fed remains fully focused on the inflation fight. In fact, no pure “doves” currently remain at the Fed. The Fed intends to bring rates to a restrictive setting and hold them there until inflation is clearly no longer a problem. Moving to 50bp rate hikes does not mean the Fed is any less committed to restoring price stability. The plan has been to get rates to neutral quickly and then begin reducing the pace of rate hikes to glide to the terminal rate. This week’s meeting only concludes the first part of that plan...

Regarding September, markets seem confused by Lagarde’s comments today that essentially dropped the ECB’s guidance from its June Amsterdam meeting entirely, while expressing that today’s larger-than-communicated rate hike does not represent a change in the ECB’s probable rate hike destination, at least in this early, more visible part of the cycle.
The conclusion some seem to have taken from those comments, as implied by one reporter’s line of questioning, is that if the previous guidance was for a combined 75 bp of hikes between the July and September meetings (25 and 50), then ‘does 50bp today with an unchanged destination mean 25 in September’?
The answer, unmitigatedly, is no. As we wrote on July 13:
Our understanding is that there is strong and broad consensus across the Governing Council on the need to, at a minimum, get rates above the lower end of the ECB’s roughly 1-2% estimate for nominal neutral rates for the euro zone — in an expeditious fashion.
And importantly for markets:
…for all the market concerns over recession and the specter of a severe energy squeeze from Russia over the winter, having come late to the hiking cycle, and with some ground to be made up before rates are “normalized,” the default mode for the ECB in the early part of the cycle will be towards 50 bp hikes
While shying away from a discussion of where exactly “neutral” might lie, Lagarde today did indeed emphasize that the ECB’s goal to “progressively” raise interest rates until it gets to a broadly neutral position has not changed. Furthermore, the TPI is not just about opening the 50bp option for today, but its mere existence in the background will allow the ECB to “walk the journey.”
Beyond the clear economic rationale to start the process of “frontloading” rates now – an important term that Lagarde also used repeatedly today — this linkage between the roll-out of TPI and the decision to hike by 50bp was explicitly laid out in both the formal communique and multiple times in President Lagarde’s press conference.
So, while we believe the Governing Council has gotten out of the business of providing explicit guidance for its next meetings, at least for now, we think that is simply to acknowledge that the old 25+50 consensus has been tossed out, and to avoid putting the Council in an awkward situation again in the future if it needs to “surprise” from expectations.
We do not see that in any way lessening the odds of 50 in September.

Another Disastrous CPI Report

With this report, we can’t ignore the possibility that the Fed steps up to 100bp at the July meeting. The Bank of Canada did exactly that this morning. The argument for 100bp is that it is too late to avoid a recession, so just embrace it. The argument against 100bp is that the Fed has kept the focus on 75bp or 50bp to dispel speculation that it would hike 100bp at the next meeting, that 100bp would induce additional unwanted volatility, at a certain point continued escalation is just reckless (creating a deeper recession than necessary), and unlike in June the Fed doesn’t have a new SEP to provide a framework to support the move.

That said, the Fed has put itself in a position where to maintain credibility on its intention to restore price stability it almost needs to find a way to escalate with each new bad inflation number. The question is what direction that escalation will take; either 100bp in July or signaling another 75bp for September. I think, and have been expecting, the Fed will opt for the latter option, but the risk is clearly weighted toward a 100bp move in July. We have a couple of days before the blackout period for the Fed to put any speculation of 100bp to rest (I don’t think the Fed wants to shift gears the weekend before the FOMC meeting again).