Deeply Behind the Curve
The Fed is deeply behind the curve on inflation. There is no other story at this point. Our baseline outlook is the equivalent of seven 25bp rate hikes this year. If it waits until March, the Fed will kick off this cycle with a 50bp hike and justify it to open a subsequent meeting for quantitative tightening. We need to put an intermeeting hike on our radar as well. Once inflation becomes entrenched, it will be difficult to reduce without a recession. I think there is a good chance the Fed will need to make a choice between recession or letting inflation go by the end of the year.
Headline inflation on a year-over-year basis accelerated to a 40-year high in January. Core inflation rose 0.6% for the month, compared to expectations of 0.5% and whisper estimates of 0.4%. Core inflation is running at a 7.2% annualized pace:
Even worse for the Fed, and the economy, super-core inflation is running at an 8.8% annualized pace:
This acceleration in super-core confirms the story of broadening inflationary pressures as told by trimmed CPI measures:
There is only one way to say this: Assuming the Fed’s primary job is price stability, the Fed has arguably missed the most significant macro call since 1966. Having clung to the transitory story for far too long while dismissing the tightness in the labor market, the Fed is now deeply behind the curve. So, what can the Fed do now? At least right now, the Fed needs to get rates to neutral as quickly as possible. I have argued that means getting to 150bp of hikes by the end of June. The Fed isn’t quite there yet, but it’s getting closer. Today St. Louis Federal Reserve President James Bullard said he wants to get rates up to 100bp by the end of June and lead with a 50bp hike in March. He added:
“There was a time when the committee would have reacted to something like this to having a meeting right now and doing 25 basis points right now,” Bullard said. “I think we should be nimble and considering that kind of thing.”
That opens the door for an intermeeting rate hike. To be sure, the Fed has to date shown no interest in treating inflation as an emergency, and so there has been no indication that the Fed can be that nimble. As I wrote earlier this week, the Fed is an institution and institutional inertia, particularly at the Board, is real. If the Fed is going to move early and fast, it’s going to be Federal Reserve Chair Jerome Powell that makes it happen. While slow to initially shift, Powell has been ahead of many of his FOMC colleagues for some time as the Fed scrambles to catch up.
Institutional inertia aside, we must be close to the point where the inflation numbers are setting some hair on fire at the Federal Reserve. How is that going to play out in policy? The Fed needs to do something significant to establish even a minimal amount of credibility on inflation. Seriously, in what world does it make sense to still be adding to the balance sheet? Here is what I am thinking:
- Baseline is that rates end the year at 1.75%. There is still an upside risk to that baseline.
- The Fed will initiate the cycle with a 50bp hike if it waits until March 16 to hike.
- If it waits until the meeting, that means five more weeks of inaction, and additional bond purchases. More realistically, at this point an intermeeting move seems like it needs to be on the table. The Fed would use that move to end asset purchases immediately and hike 25bp with an upside risk of 50bp.
I would not be surprised by an intermeeting move either tomorrow Friday or by Monday. I know, this is crazy aggressive. We have no inside information. It is just getting to the point where the distance between the Fed’s current position and reality is too wide to ignore any longer. Waiting another month while Fed presidents spin stories about only expecting three or four hikes this year is at this point nonsensical.
As a final point, I reiterate my view that once inflation becomes entrenched at a high level, it is difficult if not impossible to bring back to target without pushing rates above neutral and setting the stage for a recession. Arguably, a recession is the only way to break the inflation cycle at that point. Once you get this far behind the curve, you need to decide between letting inflation go and recession. I don’t know the Fed can avoid that decision anymore.
Bottom Line: Everything is on the table. We must have an intermeeting action on our radar at this point. The news flow is not going to get any better for the Fed and sitting on its hands amid inflation not seen in decades is doing nothing but eroding its credibility.