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.

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.

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.

Last Minute Thoughts Heading into the FOMC Meeting

Policy must adjust accordingly, but what exactly does that mean? At minimum, the Fed’s pivot will be immediately operationalized in an acceleration of tapering. The Fed will also raise the expected path of policy rates such that participants expect two rate hikes in 2022 with a risk of more. The Fed will adjust language in the FOMC statement to remove “transitory” and may also signal the economy has made “further progress towards” or is “on track to meet” the Fed’s goals.

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.

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.

The likely data highlight of the week comes Wednesday in the form of the retail sales report for November. Wall Street is expecting retail sales will moderate from 1.7% to a still strong 0.9% gain. Note that the Chicago Fed retail sales tracker predicts a more modest 0.4% gain.

Monetary Stimulus – Pumping Q1 2022
From a policy perspective, Premier Li Keqiang, Vice Premier Liu He, and the senior economic leadership in Beijing have put top priority on stimulating growth going into and through Q1 of 2022. That is due both to concerns over slowing growth going into the new year, and difficult base effect comparisons to 2021.
The Communique of the 2021 CEWC will be intended to demonstrate that China has made economic stability its top priority for 2022. From the Party’s perspective, “As long as economic growth can be maintained above 5.0% in 2022, we will be able to lay a solid foundation for maintaining average annual economic growth at more than 5.0% during the 14th Five-Year Plan (2021-2025).”

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.

Sources in Beijing are eager to present upside pressure on the Chinese Renminbi, even as the US Dollar has also strengthened, as a reflection of powerful and positive trade flows, rebounding investor sentiment, and a long-term movement of trade settlement denominations into the RMB.
But there is a limit to the government’s tolerance for an appreciating currency as the economy recovers from a sharp Q3 2021 slowdown, and officials now warn that they will intervene “if the RMB begins to hurt exports or pose a risk to financial stability.”

Bottom Line
This has the potential to be a fast-moving situation, so uncertainty is once again elevated. Still, at this point I think the most likely path forward is that the Fed accelerates tapering at the next meeting to $30 billion/month. This would both begin to adjust policy to account for supply side nature of shocks and allow the Fed to retain the optionality to hike earlier than June. This would be prudent risk management. I suspect we will see the Fed’s narrative evolve to the effect that there is growing tension between the Fed’s employment and inflation mandate such that the Fed needs to tilt policy a notch toward the latter. They can fit the likely impact of the new variant into such a narrative.

He is clearly saying Omicron will present another supply side shock. It will be slowing progress in the labor market by holding back supply when wage inflation is already “brisk.” It will be adding to inflationary pressures via supply chain disruptions. In short, it’s driving a bigger wedge between the Fed’s employment and inflation mandates. That wedge is already driving the Fed to pivot away from the employment mandate (although I think it can declare full employment whenever it wants) and toward the inflation mandate. Omicron, if realized as another Delta-type wave, would increase, not decrease, the need to pivot toward inflation. The Fed can’t keep easing into supply shocks and FOMC participants know it. Recall also that the Fed sent strong tapering signals during the Delta wave and ultimately pulled forward the taper despite Delta.
Bottom Line: It could be that Powell comes off dovish under questioning, but this testimony is clearly hawkish relative to the September version. I think the short story is that even if inflation is still expected to be transitory, it is now too persistently high to be ignored and Omicron would only make inflation worse. The public doesn’t like inflation, the politics are turning hard against the Fed and the administration, and the quite frankly inflation is comically above the Fed’s mandate, or as Powell says, “overall inflation is running well above our 2 percent longer-run goal.” I don’t think the Fed changes course unless Omicron reveals itself to be something different than Delta. That means assuming the jobs and inflation numbers come is as expected, I expect the Fed will accelerate the taper at the next meeting. Powell though could pull another move like in September and all but promise a faster tapering in January instead. Of course, I am watching for signs that won’t happen, but I don’t see those signs in this testimony.

Debate over Medium Term Forecasts
The need to build optionality in this next, and presumably final, leg of the ECB bond purchase program is predicated on the central bank’s commitment to sequencing lift-off on interest rates only after the completion of its asset programs.
And while the ECB is united (sort of), in pushing back on late 2022 rate hikes, there is a very broad and tacit understanding that these hikes could very well come soon after, in 2023, with considerably less certainty than is projected by the ECB leadership over its medium-term inflation forecasts.
Chief Economist Philip Lane, and ECB President Christine Lagarde, continue to emphasize that judging from where the ECB sits now, the medium term forecast is still for inflation to drop back below its 2% target level after spiking sharply higher this year, due to an essentially mean-reversion assumption that energy prices will fall back down, faith that supply constraints will ease in the fullness of time, and a technical drop off in the German VAT tax effect come January 2022.
In making the case for continued aggressive stimulus, ECB President Christine Lagarde, while acknowledging that prospects for medium term inflation have improved, even went so far as to emphasize in a November 15 speech that by the fourth quarter of 2022, Eurozone inflation could be back down at 1%.
That forecast, however, is due to a year-on-year base effect comparison to the massive spike in inflation now, in the fourth quarter of 2021, and does not reflect any certitude on the far more germane, and unknown, questions over the potential broadening of underlying inflationary pressures and expectations.
In a direct rebuttal to both Lane and Lagarde, Bundesbank President Jens Weidmann warned one week later that “the fallout from the pandemic could have a marked impact on the inflation setting. And it could well be that inflation rates will not fall below our target over the medium term, as previously forecast.”
Policy Implications
For policy purposes, the key point is a concern that the gap between the hawkish and dovish views is in fact not that large.
As stated by ECB Governing Council Member and Belgian National Bank Governor Pierre Wunsch, while the 2023 staff forecast is likely to remain below 2%, “it wouldn’t take much for realized inflation in 2023 to be at 2% — one or two surprises or some second-round effects, so just a fraction of everything we’ve seen in the last three months.”
These differences in forecasts will clearly not be resolved over the next days or even weeks, but the ECB will need to build optionality and policy flexibility for the upside as it gauges the momentum behind underlying inflation impulses going into 2022, including when it rolls out the new “modalities” on December 16 for the 2022 Asset Purchase Program.

Li said that in considering the whole picture of the macroeconomic situation, the MOF should study issuing a new debt quota for local governments in 2022 in advance. The amount of new local government bonds next year can be tentatively set at 4.5 trillion yuan, a slight increase over this year.
(*Note, the annual limit of newly issued local government bonds is usually passed by the country’s legislature and policy advisers in March, after the country’s “two sessions.” But the State Council could be authorized to deliver a part of the quota earlier to accelerate financing for investment projects. China issued 4.47 trillion yuan in new local government bonds in 2021, and 4.55 trillion yuan in 2020).
Li expressed satisfaction with the current monetary policy and reiterated the need to make macro policies more forward-looking and targeted, step up cross-cyclical adjustments, and maintain major economic indicators within the proper range and ensure a stable job market.

“At present, China’s crude oil supply is sufficient, the supply and demand of crude oil is very balanced. Although US President Joe Biden wants China to release its strategic petroleum reserves along with the US, China does not have the need to release our SPR immediately. We will take caution in releasing strategic crude oil reserves,” said one senior source.

In practice, China publicly announced a modest release of its SPR twice over the last fourth months, but our understanding is that China has adjusted SPR data almost every month under its own timetable, without any publicly announcement. Perhaps more to the point, on oil policy, China is keen to maintain its relations with Russia and Saudi Arabia rather than be seen to simply embrace a US request.

European Central Bank officials, concerned by the notion that markets may start pricing “premature” rate hikes some twelve months into the future, have pushed back on expectations of a fourth quarter 2022 liftoff from the current negative 0.5% benchmark deposit rate.
*** But even as they insist that this pricing does not conform to the ECB’s own reaction function and forecasts, our understanding is that there is a strong likelihood the ECB will seek to build some optionality into the revised Asset Purchase Program at its upcoming Governing Council meeting on December 16 to allow for a more rapid run-off of the bond purchasing program should inflationary pressures persist.