...Xi stressed that the most important task in the next six months is to ensure economic stability, financial market stability, the stability of the RMB exchange rate, and the stability of attracting foreign investment. He particularly stressed that it is necessary to strive for economic growth in the current fourth quarter of 2022 to return to the “normal” level, that is, 5.0%.
Xi particularly emphasized the need to take corresponding measures to stabilize the stock market, to ensure that the RMB does not depreciate in a disorderly manner, and to make foreign investors have confidence in China, as well as help Hong Kong to stabilize its financial market...

On tomorrow’s FOMC meeting, our baseline hasn’t changed. The Fed will discuss the pace of rate hikes at upcoming meetings, and Federal Reserve Chair Jerome Powell will acknowledge the discussion, but will most likely claim that the Fed makes policy decisions on a meeting-by-meeting basis with nothing decided in advance.

At issue is how much guidance Powell provides regarding the path of monetary policy. We believe he will retain the option of 75bp in case the Fed needs to respond to upside surprises to the inflation outlook. That said, we don’t think he will leave us flying completely blind; we think he will need to define the Fed’s reaction function more carefully...

...We don’t think Powell will embrace the idea of a pause at the SEP-implied terminal rate. Although a group of presidents has been unusually vocal in their desire to find a place to pause, that’s still too far in the future to commit to, and could easily change with the December SEP. Indeed, our expectation is that the dots move higher again in December, albeit a nudge rather than another leap...

...The Fed will follow through with another jumbo-sized rate hike this week but will signal a high likelihood that this will be the last 75bp rate hike in the cycle...

...I repeat my mantra that it is ill-advised to bet against the consumer in the absence of substantial job losses. To be sure, we get a fresh read on the labor market this week, but initial unemployment claims clearly tells us that the labor market is not coming unglued:

...That said, as with US rates, European rates traders have also latched on to a deceleration story to aggressively drop their estimates for the terminal rate for this cycle. While reporters kept pressing Lagarde on whether she agreed with the market’s expectations of a 3% peak, that bird flew some time ago, and markets have already dropped well below that, to a bit over 2.5%.
As to where markets are today, color us skeptical that the cycle will end at 2.5%. Barring the materialization of a deeper geopolitical shock, for which we must of course always be on alert, we suspect that is a view that is shared by many ECB officials...

A resurgence in Australia’s inflation rate rate to a 32-year high will challenge the Reserve Bank of Australia (RBA) to weigh another large rate hike when it meets next week though it will probably settle on 25 basis points.
Consumer prices rose 7.3% in the 12 months through the September quarter, following a 6.1% rise in the prior quarter and marked its highest annual rate since 1990. The data reflected higher prices for food, fuel and housing and showed a broadening into services.
The latest outcomes will prompt more serious consideration of 50bp than a slower inflation outcome would have required at the November 1 board meeting. The RBA however will not panic and reverse last month’s step-down to a slower pace of moves in response to one, albeit important, data point...

...The Bank will use next week’s interest rate announcement that accompanies the monetary policy decision to reiterate its option to resume larger hiking increments if necessary.
RBA deputy governor Michele Bullock said in a speech on October 17 that the RBA’s schedule of 11 board meetings a year provides it more flexibility on the size and timing of rate increases than most other major central banks.
“It also means that if we increase interest rates at every meeting, we can potentially move much faster than overseas central banks,” she added.
The latest inflation spike demonstrates why the RBA’s October 4 step down was accompanied by language that retained a clear and stridently hawkish hue, just as it will again next week.
It almost certainly locks in at least another 25bp hike in December to 3.10%, and likely more moves through the first quarter of 2023...

...More important to RBA thinking will be how the report impacts its forecast path for inflation through 2024. A higher inflation peak would require a higher peak in the cash rate, beyond 3.50% next year.
That elaboration probably will come in upward adjustments to the inflation path in the quarterly Statement on Monetary Policy (SMP) that follows this meeting by a few days, on November 4...

The Fed is poised to raise rates 75bp next week and further rate increases are expected at upcoming meetings. Still, Fed presidents are increasingly vocal in their assessment that the current SEP-implied terminal rate of 4.50-4.75% is not just a near-term goal but an opportunity to pause and assess the impacts of the Fed’s actions. The forthright and consistent nature of their comments suggests they expect the support of their colleagues on the Board. We think there remains upside risk to the terminal rate (it is easy to see the Fed managing market expectations by dropping down to 50bp in December while nudging the terminal rate higher), but the discussion is turning toward the ability to slow the pace of rate hikes and find a terminal rate as long as inflation does not worsen further in the near-term. Even if the Fed follows this road, it will retain a bias toward future rate hikes and argue it can raise rates later in 2023 if inflation doesn’t fall or fall far enough to see a return to price stability with a reasonable forecast horizon.

Evolving the Narrative
Bottom Line: Fed presidents increasingly sound like 4.5-4.75% is not just a near-term objective, but also a medium-term objective in that they believe it will be sufficiently restrictive – if held for a long time – to restore price stability. The destination which members agreed to at the September meeting as we have written also appears to be based more on a “feeling” than any type of hard evidence, and such feelings have gotten the Fed in trouble this year.

...The European Central Bank will hike its benchmark deposit rate by 75 basis points, from 0.75% to 1.50%, when the Governing Council convenes again in Frankfurt next Thursday, October 27 for its monetary policy meeting.
With so many officials having already come out in force to express their strong preference for another 75bp hike, it would indeed, as one official quipped, be truly bizarre if the ECB was not to hike by 75 bps next week...

...Eyeing the Next Two Meetings
The near-term, broad policy consensus among ECB officials beyond the October meeting remains as we laid out in detail in SGH 9/29/22, “ECB: Staying the Course.” If anything, these expectations have been reinforced since by ECB and Eurosystem officials in speeches, and most notably in detail by Banque de France Governor Francois Villeroy de Galhau.
The December 15 meeting will entail a debate between another 75bp hike to 2.25% or a 50bp hike to 2%.
Many officials are leaning to a modest step down in pace from the 75s, to 50, including Villeroy, and we believe it would be fair to say this is a rough, if not rather loosely held, consensus at this time.
But there are many officials also already leaning towards another 75bp in December, and it seems a reasonable bet to us that the continued poor inflation data going into the turn of the year, with core pressures remaining high even if headline stabilizes, will keep our (and the market’s) lean towards 75.
With the usual caveat of considerable uncertainty around the turn of the year, energy prices, growth concerns, and most importantly a true sense of the underlying dynamics behind core inflationary pressures, the strategy as we also laid out in the Sep 29 report is to then decelerate the pace of rate hikes once the ECB gets above a 2% handle, perhaps to 25s (if they can get away with that), as the ECB starts the process of shrinking its balance sheet...

...As to timing, some financial wire services predict that the balance sheet reduction will not start until March 2023, but we believe this is off the mark.
We expect the ECB will know by its February 3 meeting, the first meeting of 2023, what it intends to do, decide, and announce the details at that meeting. With a massive balance sheet clearly working at odds to monetary policy objectives, the ECB will then start the gradual reduction process in the same month — February...

...The calendar here seems important. The SEP implies the last hike is in January, a 75-50-25 path, and by extension that the last hike is right in front of us. If Fed speakers keep leaning into the SEP as we move closer to that point, the pause will look more real. Imagine that in the context of the current data flow; it would suggest pausing even with high inflation. Also imagine the possibility that Powell at the next press conference says that the “meeting discussion was in the context of the September SEP.” That will be only two meetings away then. They must have a good idea what they are planning over the next two meetings.
Strategically, the Fed could manage this debate by finding a consensus between those focused on current high inflation and those worried about the risk of overshooting. The Fed can step down to 50bp at the December meeting, thereby acknowledging the more dovish participants’ concerns while at that same meeting raising the SEP-implied terminal rate a notch to reflect the still too-high inflation data. Such a continued upward drift in the terminal rate remains our base case. Rather than shortening the cycle as Bullard suggests, the Fed elongates the cycle with what eventually become 25bp rate hikes. Remember, Waller said that there will be a substantial discussion of the pace of rate hikes at the next meeting; that’s where FOMC participants would develop a consensus around the next stage in the cycle...

Chips Ban Retaliation

Our understanding is that five ministries and commissions under China’s governing State Council are jointly studying countermeasures against the latest round of US chips bans against China. The Ministry of Commerce is expected to announce countermeasures against the US shortly after the 20th National Congress at the end of this month or early next month.

In the words of a senior Chinese official:
The move [chip ban] is the toughest measure the US has taken against China’s high-tech sector so far. It does have a serious short-term impact on China, but it will definitely not cause China’s high-tech companies to go out of business or bankrupt. How much impact the latest move has on China’s artificial Intelligence and chip sectors depends on how broadly Washington enforces the restrictions. In the long run, Washington’s extreme export control toward China will be difficult to sustain….

...EU energy ministers also agreed as we had expected to task the Commission to develop a different price benchmark for LNG so that the sector can dump the volatile and no-longer-representative-of-reality Dutch Title Transfer Facility (TTF) that is linked to pipeline gas. That will take time too.

EU energy ministers are to meet in November to approve whatever the Commission produces on October 18th...

...There was still no agreement on Wednesday on introducing any price caps on gas — for all the reasons discussed in our last report.

And while it is unclear yet if any price caps will be presented as an option by the Commission on October 18 or not, we believe that option remains highly unlikely...


...On Wednesday, October 12, European Union energy ministers agreed that the European Commission should present on October 18 a proposal for joint natural gas purchases by the whole EU, just like the bloc did for COVID-19 vaccines, to avoid one EU country outbidding the others.
This is relatively low hanging fruit in political terms, although it does involve a change of heart by Germany and the Netherlands, whose governments some time ago did not support joint purchases as they believed they were in good position to negotiate deals and pay what would be needed if necessary to keep their industries running.
The joint buying, however, would not start before mid-2023, the ministers agreed, so it is not an imminent measure, even if agreed sooner.

Joint Issuance
Despite press reports to the contrary, the idea of new, jointly issued EU debt to deal with the energy crisis does not seem to be happening for now.
The calls for new joint debt issuance have come largely from the Commission and given that it was French and Italian commissioners calling for it, one might reasonably suspect these had the blessing of Paris and Rome. But there is still strong pushback from Germany, and the usual group of fiscally conservative northern countries hiding behind Berlin.
The German case is simple and remains that there is still a lot of unused money from the recovery fund and the RePowerEU project that could finance whatever is needed, and there is therefore no point in borrowing more if the EU has not used what it has.
German officials choose to highlight the bigger figure of 600 billion euros still unspent from the EU recovery plan to make that case – which is the amount of money that has yet to be paid out from the recovery fund since actual disbursements so far have amounted to only around 200 billion euros...

...The 19th Communist Party of China Central Committee concluded its seventh plenary session in Beijing on Wednesday afternoon, local time (October 12).
Xi Jinping Thought Through 2049
As we have written before, the seventh plenum decided to submit the draft amendment to the CPC Constitution to the 20th Central Committee emphasizing “Comrade Xi Jinping” as a “well-deserved” “people’s leader,” and to explicitly write into the CPC Constitution the statement of “Two Affirmations” that says: The Party has established Comrade Xi Jinping’s core position on the Party Central Committee and in the Party as a whole and has defined the guiding role of Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era...

...We think the more hawkish FOMC participants have the upper hand in these arguments. After so many missed predictions that inflation would soon decelerate, the doves have an uphill battle when arguing for a pause ahead of sufficiently supportive data. But the more restrictive policy becomes, the bolder the doves will become.

Bottom Line: The SEP-implied terminal rate is as little as three meetings away. It is right on top of us. And the Fed will step up the discussion of slowing the pace from 75bp to 50bp, as that too is in the SEP. There will be a push to find a place to pause even if inflation remains elevated. We saw that on display this week. Ultimately though we think the more hawkish FOMC participants will continue to argue that the Fed needs to maintain upward pressure on rates until the data gives up something in the form of sustained softer inflation or weaker labor market outcomes. There is a path to reaching the terminal rate in January, although we think the data won’t allow for that and the hawks will continue to drive policy rates above the current SEP-implied terminal rate...

...The Fed continues to keep us focused on the current SEP-implied terminal rate. Buried inside that direction is an implied step down in the pace of rate hikes. Eventually the Fed will need to find a time to start gliding to the terminal rate, but the July meeting was too early and left market participants with too little direction on the Fed’s reaction function. After the third 75bp rate hike in September and a fourth in November, rates will be high enough that the Fed can more credibly tell a policy lags/two-sided risks type of story. Still, at some point the data needs to cooperate before the Fed can have any real confidence that the terminal rate is in sight...

...So, having already tightened 250bp since May, the RBA broke ranks with its global peers this week by delivering a smaller rate hike than expected, and instead pitched its cash rate at 2.6%, right around the so-called neutral rate (which neither stimulates or tightens conditions)...

...Worse though is that the BLS revised the series higher such that if core inflation continues at the average pace of the last 6 months, 0.38%, it will end the year at 4.9% compared to the 2022 forecast of 4.5% in the Fed’s most recent SEP. This suggests that the underlying momentum in the inflation data heading into 2023 will be higher than the Fed anticipated just a couple of weeks ago, and raises the risk that policy rates will climb above the 4.5-4.75% median dot in the SEP...

...QT and Balance Sheet Discussions

Putting it all together, the first meeting of 2023 will be the point at which the ECB, having crossed into some sort of neutral policy zone, will as suggested by ECB President Christine Lagarde in a speech earlier this week then decide on the appropriate mix of additional interest rate hikes and balance sheet reduction.
With quantitative tightening as a major policy decision now looming on the horizon, technical work is underway already to map out feasible options, and the Governing Council will start these discussions at the upcoming, October meeting...

The Fed will retain a hawkish posture until the data breaks in favor of sharply lower, and sustainable, job growth or inflation. We think it is literally impossible to get compelling evidence that the Fed is on a path to price stability by the time of the November FOMC meeting; even getting such evidence by the December meeting feels like something of a stretch. And we can’t emphasize enough how important it is that we see such data before we can expect the Fed to pivot to a meaningfully more dovish stance. It is simply the case that any more dovish voices within the Fed have been proved wrong time and time again during this cycle and those voices can’t gain any traction at this juncture with theories alone. It needs to be hard evidence.

...Worse though is that the BLS revised the series higher such that if core inflation continues at the average pace of the last 6 months, 0.38%, it will end the year at 4.9% compared to the 2022 forecast of 4.5% in the Fed’s most recent SEP. This suggests that the underlying momentum in the inflation data heading into 2023 will be higher than the Fed anticipated just a couple of weeks ago, and raises the risk that policy rates will climb above the 4.5-4.75% median dot in the SEP...

...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...