Thoughts Ahead of CPI Number
The BLS releases the January CPI report tomorrow. Wall Street expects core-CPI inflation to be at 0.5%, consistent with the 0.45% prediction from the Cleveland Fed inflation tracking numbers. This will be an influential report given the Fed has us primed to watch the near-term inflation numbers to gauge the direction of policy. Some last-minute inflation thoughts heading into this meeting:
1. 50bp? Inflation at or above expectations will likely trigger market participants to increase probabilities of a 50bp rate hike in March. The Fed has set these dynamics in motion by not dismissing outright the idea of 50bp. If markets price in 50bp then the Fed will need to meet it or there will be an effective easing of monetary policy as market participants adjust to what will be perceived as a less-hawkish reaction function.

Considering that we already anticipated the Fed would hike in the March, May, and June meetings with high probability that one of those would be 50bp, the Fed will be moving in our direction. The minimum number of rate hikes we see in the first half of the year is 75bp. There is plenty of room for upside risk even in the near term. As we argued last week, positioning policy to address higher than anticipated inflation argues for three 50bp rate hikes.

But the real movement was in policy communications, where we had expected the ECB would not definitively rule out 2022 hikes, which would keep markets priced for a full hike by Q4 2022. Lagarde went significantly further than that, and in effect completely tossed out the ECB’s rapidly eroding “base case” scenario of 2023 rate hikes today.

Lagarde did repeat the ECB’s commitment to its sequencing of an end to the Asset Purchase Program first (“shortly”) before hiking rates. But that commitment, as run by some financial newswires, was far from headline news. The real headline is that President Lagarde has all but explicitly opened the door to ending the APP program early once it reassesses the data in March and June.

We will venture to suggest that will translate to an end to the APP bond purchase program in Q4 of 2022 now at the very latest (this was our base case before) – with a more likely base case now of a Q3 end to bond purchases, and liftoff to follow “shortly” after.

More to the point, after attending the opening ceremony of the Beijing Winter Olympics, Xi and Putin will witness the signing of nearly 20 contracts and documents between China and Russia, including on financial, energy, space, and military cooperation, and on a new Sino-Russian natural gas pipeline.

Regarding tensions with Ukraine and the West, our understanding is that Xi will give China’s formal backing to Putin’s drive to “develop a legally binding security” agreement for Russia with NATO, something which China has not done yet to date.

In a related move, our understanding is that the two sides will also sign a document on the construction of a Sino-Russian West-Route Natural Gas pipeline (the Soyuz Vostok gas pipeline construction project).
Xi apparently agreed with Putin in principle to build this second Sino-Russian gas pipeline with the stated intention of supporting Putin in his attempts to extract security demands from the United States.

This pipeline will pass across Mongolia and will be an extension of the “Power of Siberia-2” gas pipeline. The full capacity of the 4,000-kilometer pipeline is expected to be 50 billion cubic meters per annum of natural gas, about 1.3 times the capacity of the Sino-Russian East-Route Natural Gas pipeline, and it is expected to be completed by 2025 at the earliest.

Having jacked up their 2022 inflation forecasts already last December, these continued elevated inflation readings may not move the needle much for 2022 when the ECB reassesses at its next quarterly review on March 10. At least that is the current thinking.
But for the more critical policy horizon, the ECB will raise its 1.8% inflation forecast in March for 2023 and 2024, already a whisker away from the ECB’s 2% target (more on this below), and ECB communications are already hinting at this shift. That will finally create room for the start to the discussion of a normalization cycle from the still deeply negative policy interest rates.

With that in mind, and continued upside pressure on 2022, it is hard to see markets removing the optionality of a Q4 end to the APP program and a late Q4 rate hike, or for ECB officials to definitively rule that out, even as they continue to stick to their base case scenario. Conversely, under the ECB’s guidance and reaction function it is hard to envision a hike earlier than that, unless the inflation data goes seriously awry.

Most importantly, however, the ECB models also assumed powerful structural forces that for the past two decades have pulled underlying inflation around, if not frustratingly below, the 2% level.

But energy prices, in particular natural gas prices, have not just skyrocketed across the Eurozone, but remain stubbornly high, and are increasingly hard to simply “look through.” These elevated prices we are told are feeding through for example into fertilizer costs, which in turn fuel elevated food prices that could go on into next year. Perhaps even more importantly, they are also feeding into consumer price expectations.
Similarly, ECB officials appear less willing to completely look through what have been skyrocketing, and continued elevated, raw materials prices.

In the past, Euro area retail chains wielded considerable clout in dictating prices and absorbing temporary spikes in raw material prices. But in the words of one official, that is now “more or less over,” and the higher costs are being passed through to consumers. This official goes as far as to say the long period of too low inflation is now over, and the Eurozone is already back in the cycle of “regular inflation.”

Foaming the runway for a rate hike will be the key outcome of this week’s FOMC meeting. We anticipate the Fed will use this meeting to signal a March rate hike by declaring the full employment trigger has been or soon will be met. The Fed most likely will not end asset purchases faster than planned. Yes, continued asset purchases stands as a contradiction to the Fed’s planning to begin quantitative tightening soon after the first rate hike. That said, there is little to be gained by ending asset purchases early given that continued asset purchases do not interfere with a March rate hike.
Federal Reserve Chair Jerome Powell will use the press conference to reinforce the current policy narrative. The key element of that narrative is that inflation threatens the health of the job market if left unchecked. A second element of that narrative is that like high unemployment, elevated inflation has equity consequences. In order to ensure that inflation tracks back to target, the Fed needs to begin removing policy accommodation.
Powell likely won’t provide many new details about the Fed’s quantitative tightening plans. FOMC participants will discuss options for the balance sheet but likely won’t reach final conclusions. The Fed typically likes to discuss these kinds of policy decisions for a few meetings to help build a consensus. Powell will likely reiterate the broad outlines of the discussion as already revealed by other speakers and the minutes of the last meeting. Those conversations to date leave the impression that the Fed expects the balance sheet reduction will occur sooner, move faster, and go further than the last cycle.

Our expectation is that along with a rate hike in March, the Fed signals four rate hikes in the March SEP. The first two of those hikes, as well as quantitative tightening, are highly likely to occur. The incoming data will determine whether the Fed delivers an additional one, two, three, or more hikes after those early policy actions.

Among the series of meetings that were held by China’s State Councilor and Foreign Minister Wang Yi with the foreign ministers of numerous middle eastern countries between January 10 and 15 in Wuxi, China, the most interesting perhaps for markets were his meetings with Saudi Arabia’s Faisal bin Farhan Al Saud on January 10, and with Iran’s Hossein Amir-Abdollahian on January 14.

In Wang’s meeting with Faisal, the two foreign ministers discussed China’s crude oil supplies, and agreed to hold a first ever China-Arab Summit in Riyadh in 2022 (see SGH 1/19/22, “China: Oil Imports and Mideast Politics”).
Our understanding is that the two foreign ministers also agreed to conduct a pilot scheme to promote the use of RMB/Riyal to settle bilateral payments “as soon as possible.” The goal, it was agreed, would be to ensure the partial settlement of crude oil transactions in RMB/Riyal, bypassing the US dollar, by 2025.

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.

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.

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.

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.

The next big data release is the retail sales report. Wall Street is looking for a 0.2% gain in retail sales ex-autos but the Chicago Fed tracker anticipates a 1.3% decline:



The Chicago Fed number has been a good predictor of the direction of the miss relative to consensus.

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.

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 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.

All Focus on Q1 GDP
Sources continue to stress Q1 of 2022 as the key to ensuring China’s economy can grow above 5.0% or even 5.5% year on year in 2022.
At present, the top priority for governments from the central to local levels is to ensure stable economic growth, and a series of macroeconomic policies and measures will be introduced to stabilize economic growth specifically for Q1. Our understanding is that the goal of the State Council is to achieve economic growth of around 4.0% year on year in Q1.
If Beijing can manage a GDP growth rate of around 4.0% in Q1, it not only means that China’s GDP would likely reach 5.0% or more in 2022, but also that China’s “economic aggregate” would reach 120 trillion yuan in 2022, an increase of about 10 trillion yuan from 2021.
However, already cautious officials point to the challenge of even meeting the base effects of the 18.3 % GDP growth rate of 2021 Q1 and warn that it is not going to be easy to achieve their target of 4.0% year on year growth for Q1 of 2022.
The State Council will send 28 inspection teams and working groups to all 31 provincial-level regions from January 4 to inspect and guide the current economic work and sent 16 inspection teams already to locals between December 15 and 29.

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.

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.

The ECB will not change the sequencing of rate hikes to follow the end of asset purchases, and the Governing Council has repeatedly pushed back on the likelihood of 2022 rate hikes. That is probably even more so the case given the likely dampening effect of the surging Omicron variant on travel, hospitality, and economic activity at least in the very near term. But importantly, sources have also stressed that this push back does not extend to 2023, and there are no “guarantees” of no hikes beyond 2022. Frankly speaking, even the late 2022 pushback, while seen as extremely unlikely, is not 100% ironclad.

This means the ECB will not commit to asset purchases beyond 2022, and will, as we stated in our November 22 report, very likely seek flexibility to start the year higher, but gradually unwind the Asset Purchase Program through the course of the year. Flexibility of course can go both ways, resulting in higher as well as lower purchases, but the maneuverability that is sought is to end QE by the end of 2022 if all pans out as expected.