Monday Morning Notes, 02/07/22
If You Don’t Have Time This Morning
Assuming the hawkish data flow continues, market participants will likely continue to price in more rate hikes, including a higher probability of a 50bp hike in March. The Fed will need to push back harder if it wants us focused on a 25bp hike. Leading with a 50bp hike could be perceived as an emergency move, but nothing in the Fed’s actions to date suggests it views inflation as a potential crisis.
Recent Data and Events
Covid’s impact on the economy continues to diminish over time. Job growth surprised substantially on the upside with a gain of 467k. November and December numbers were revised upwards as well although total employment for 2021 rose only 217k after revisions that revealed much more consistent job growth last year than initially reported:
The implication is that Covid is driving much less of the underlying dynamics of the U.S. economy than widely believed. Even the massive Omicron wave did not restrain job growth as expected, but instead revealed itself in reduced hours worked due to illness:
This likely created an upward impact on average wages:
And a slower pace of aggregate payroll growth, something I am watching as an indicator of spending capacity:
These effects will likely be largely reversed in the February data. The underlying trends of strong job and wage growth remain intact. The Beveridge curve continues to indicate that even if the data is returning to its pre-pandemic relationship, it will return to a region indicative of a super-hot job market with rapid wage growth:
On the household survey side, the unemployment rate edged up to 4%, and this was not influenced by the annual population control adjustment. On one hand, this might give some comfort to the Fed that the pace of the unemployment decline is moderating. On the other hand, the recent pace of wage growth at the current unemployment rate already suggests the economy is past full employment. The labor force participation rate edged up 0.3 percentage points. While some Fed officials may see this as an additional reason for patience, the updated population controls accounted for the entire gain.
Upcoming Data and Events
CPI will be the main event in an otherwise light week for data. January core-CPI is expected to be up 0.5%. Inflation coming in near or above expectations will pressure the Fed to step up the pace of rate hikes. Surprises on the downside will lead the Fed to signal easier policy in the latter half of the year. The Fed should be looking through any decline in used car prices like they looked through the increase all last year, but the Fed has been inclined to embrace any story that says inflation isn’t a problem so it might jump on any signs of improvement. Also watch the University of Michigan inflation expectations numbers on Friday.
Scheduled Fed speak this week is also light with just Governor Michelle Bowman and Cleveland Federal Reserve President Loretta Mester, both on Wednesday.
|Thursday||CPI, MoM, Jan||0.5%||0.5%|
|Thursday||Core-CPI, MoM, Jan.||0.5%||0.6%|
|Thursday||Initial Jobless Claims||235k||238k|
|Friday||Univ. Of Mich. Sentiment, Feb. P||67.5||67.2|
|Friday||Univ. Of Mich. 5-10Y Inflation Exp., Feb. P||3.1%|
Fed Speak and Discussion
We have long argued that the Fed’s hawkish pivot was not complete. With the December SEP still signaling accommodative policy into 2024, the Fed still has plenty of room to become more hawkish. Moreover, the data continues to signal the Fed needs to turn more hawkish, and it is only a matter of time before the Fed makes another abrupt shift. There is a menu of options available for the Fed to respond to the incoming data, including a 50bp hike in March. Logically, that is a rational path for the Fed to take, and it must be on the table. That said, it seems to require the Fed think of inflation as an emergency, but there is no institutional support for that kind of thinking yet.
The surprise in the January employment report was that, contrary to conventional wisdom, Covid is no longer a fundamental driver of activity. It is a secondary factor. Instead of leading to massive jobs declines, the Omicron wave simply cut into hours as employees called out sick. The Fed was prepared to look through the expected weakness. Now instead it needs to embrace the strength of that report. It is simply becoming impossible for the Fed to say with any credibility that the jobs market is not overheating.
The path of policy relative to the Fed’s current baseline (just three hikes in the December SEP!) needs to be adjusted accordingly. The Fed can choose from a number of options to escalate relative to the current baseline of a 25bp rate hike. The most likely, and not mutually exclusive, options are:
- An intermeeting rate hike prior to the March meeting.
- A 50bp rate hike at the March meeting.
- Signaling a 50bp rate hike at the May meeting.
- Using the SEP to signal a more rapid pace of rate hikes.
- Signaling a rate hike at every meeting in 2022.
- Using the SEP to signal above neutral rates in 2023.
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.
I can tell you why the Fed could lead with a 50bp rate hike, I can’t tell you that it will. The case for a 50bp rate hike is straightforward. The Fed has fallen behind the curve and needs to catch up and the only way to catch up is to, you know, actually hike rates. There is plenty of time between now and the blackout period to signal 50bp and market participants are obviously open to the idea given the increased betting on 50bp. The data is calling for it, and the politics are calling for it. There is nothing in the Fed’s way. Well, almost nothing.
The Fed’s experience centers on managing financial crises in a low inflation economy. But that’s not the economy it faces now. Not having faced a challenge like this since the 1970s, this Fed has virtually no experience with inflation. For nearly three decades the Fed has only had to manage inflation with relatively minor deviations from 2%. But over the past three months, core inflation is running at a 5.8% annualized pace, wage growth at a 6.9% annualized pace, unemployment is at 4%, job openings dwarf the number of unemployed and yet THE FED IS STILL ENGAGED IN QE. The Fed has yet to embrace the current situation as a policy emergency even though I know many of us have done so. Policy is about getting to neutral, not about containing inflation.
The Fed does not have an institutional framework for thinking of inflation as an emergency. A 50bp rate hike in March, or an intermeeting hike, would be treating inflation on par with a financial crisis but this Fed has shown little sense of urgency in addressing rapidly rising inflationary pressures. Institutionally, the Fed committed to the pre-pandemic policy consensus that low demand is always and everywhere a problem, inflation can never deviate from 2%, and consequently the primary focus should be on jobs not inflation. That consensus was operationalized and applied via a hyper-dovish interpretation of a new policy framework. We have seen over and over again that the Fed will move rapidly to respond to a downturn in the economy. We have no evidence to suggest the Fed will pursue the mirror on the upside.
I don’t think the Fed has a sense of what a 50bp rate hike would accomplish that couldn’t be accomplished through the dots. When pressed, Fed speakers have hemmed and hawed about the possibility of a 50bp hike, but the clear message is that they really don’t want to do it. One reason is that it would be an admission that the Fed is behind the curve. But this comment from St. Louis Federal Reserve President James Bullard, via Bloomberg, highlighted a more fundamental issue:
“Fifty basis points, I don’t think helps us — at least sitting here today, I don’t think that really helps us,” Bullard said Tuesday in a Reuters interview live-streamed on Twitter. “I think we can get a disciplined approach to raising the policy rate and the expectations are already in markets.”
Bullard has been on the leading edge of the Fed’s hawkish tilt, and so if he isn’t seeing the benefit of 50bp, who else is seeing the benefit? Bullard’s invocation of the “expectations” provides guidance on this point. I think the Fed views the expected path of rates as more important than the actual rate hikes. Recall Powell at the December press conference:
You know, the question of long and variable lags is, is an interesting one. That’s, that’s Milton Friedman’s famous statement. And I do think that in this world, where everything is— where the global financial markets are connected together, financial conditions can change very quickly. And my own sense is that they get into—financial conditions affect the economy fairly rapidly, longer than the traditional thought of, you know, a year or 18 months. Shorter than that, rather. But in addition, when we communicate about what we’re going to do, the markets move immediately [in response] to that. So financial conditions are changing to reflect, you know, the forecasts that we made and basically, which was, I think, fairly in line with what markets were expecting. But financial conditions don’t wait to change until, until things actually happen. They, they change on the expectation of things happening. So I don’t think it’s a question of having to wait.
By this logic, raising the path of rates would have the same impact as a 50bp rate hike. Why hike 50bp when you could get the same result by moving from three to five or six rate hikes in the SEP? Nothing the Fed does now will have an immediate impact on a lagging variable like inflation.
A 50bp rate hike makes most sense if the Fed could place it in the context of a clear objective. But at the moment, the policy goals are vague. There is no forward guidance beyond “we are hiking in March and after that anything is possible.” There is no clear goal of where policy needs to be or how quickly it needs to get there. We just know from Powell that it needs to be better positioned and we can surmise that means nearly neutral, but by July or December or some time in 2023? The policy uncertainty is a consequence of having no firm opinion on the inflation outlook. Even after the pivot, the Fed is trying to slow walk policy on the hopes that inflation will ease in the latter half of the year. There is no proactive effort to bring inflation back to trend. The Fed follows a fundamentally passive policy approach. A 50bp rate hike is just a random move in this context. The Fed could make 50bp meaningful by defining a more concrete policy path. That path would be “we need to raise policy rates to neutral before the fall.” In that case, the rationale behind 50bp rate hikes becomes obvious – but it also requires the Fed to think that actual rate increases are more important than the projected path of policy.
It feels to me that if the Fed were to lead off with a 50bp rate hike in the context of an articulated strategy, Powell would need to take the lead on defining that strategy. The idea of “nimble” policy outside of a crisis implies a “Greenspan-esque” understanding of the ebb and flow of the economy and markets. I don’t see the institutional capacity for that kind of practitioner’s approach to policy. As noted earlier, the institution has gone all-in on the certainty of the pre-pandemic economy. There is not really any institutional guidance for addressing high inflation other than “don’t let the 1970s happen again.” Fed models estimate a very small impact on inflation from rate hikes:
How does that provide guidance for the current situation? It says massive rate hikes are needed to pull inflation back to 2% if the underlying equilibrium has shifted. It’s not obvious to me that the institution has the political willpower to allow unemployment to rise if necessary to contain inflation under that circumstance. And while the institution might be able to move nimbly in response to a financial crisis, I doubt the same is true when it must cut from its ideological anchors and hike rates aggressively. Nothing is going to quickly change from the bottom up. It will have to be from the top down.
Assuming the data flow follows in the path of the employment report, markets will likely price increasingly higher probabilities of a 50bp hike in March. The lack of substantial pushback on the idea of 50bp will entice market participants to keep pulling forward rate hike expectations rather than only raise the number of expected rate hikes later in the year. We could very well go into the March meeting with 50bp fully priced in and a Fed uncertain of whether they want to lean into the market pricing. I don’t think it will come to that though. If we get to that point, the Fed will likely take the gift the market is offering. Indeed, a “nimble” approach to getting to neutral would mean taking advantage of such opportunities. If the Fed doesn’t want to go 50bp, Fed speakers will need to start taking a more concrete stand.
I am going to try to circle back to the balance sheet policy later this week, that’s a whole separate mess. The short story there is the Fed has yet to decide on what they want to accomplish on that front but maybe can form a consensus quickly once the staff lay out some options. Still, there may be sizable disagreements over the fundamental objective of QT, whether the Fed wants to present it as a complement or replacement for rate hikes, and the question of asset sales, particularly with regards to MBS.
Where does this leave me? I am pretty confident the Fed doesn’t want to lead with 50bp because they don’t have a framework for such a move if the Fed can accomplish its objective via an increased pace of 25bp rates hikes. Still, nor can I rule out the option, and if the data retains its hawkish tilt and the Fed speakers don’t push back, pricing will continue to move in that direction. Moreover, the Fed could reposition with a strategy in which to place a 50bp March rate hike or use the March meeting to firm up a strategy that includes a 50bp move in May. Watch for that repositioning. Regardless of 50bp in March or not, incoming data is likely to drive the Fed into pushing rates more quickly toward neutral, so I would anticipate that with five 25bp rate hikes now priced into the market, we will be heading toward six. I don’t think the Fed’s hawkish pivot will be complete until it is pushing rates above neutral, and we haven’t even gotten off the floor.
Good luck and stay safe this week!