Tim Duy’s Fed Watch, 1/5/21

Published on January 5, 2022
SGH Insight
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.
Market Validation
Bloomberg 1/11/22

The drumbeat for the Federal Reserve to
implement four quarter-point interest-rate hikes this year is
growing -- and with the speed that markets have been moving,
there’s a possibility that traders may soon look to protect
themselves against the risk of even faster tightening.
Swaps are already indicating the central bank’s target will
be 88 basis points higher by the end of this year -- seen by
many as a sign the market is baking in three hikes, plus the
possibility of a fourth in 2022 -- and momentum is building for
the first increase to take place as soon as March. With U.S.
inflation data ahead this week, as well as testimony from top
Fed officials, it could be just the beginning of a bigger
repricing.

Fed Minutes Lay Out March Hike and QT

The minutes of the FOMC meeting confirmed the major themes we have discussed in detail in recent weeks. The Fed made a hard pivot at the December meeting and turned its attention to a March liftoff from the zero bound. Moreover, the Fed will soon follow that move with quantitative tightening to begin unwinding the growth of the balance sheet. This isn’t the last cycle when the Fed slow-walked every aspect of policy normalization. Instead, policy normalization is already in play and happening very quickly.

Per usual, there is so much in the minutes that it is hard to know where to begin. Still, some key points stand out. On the timing of the first rate hike, the Fed is just waiting to declare victory on the employment trigger and we have argued they could do that at any time now. It’s just a matter of pulling together a consensus. The minutes revealed that consensus is very, very close at hand:

Participants pointed to a number of signs that the U.S. labor market was very tight, including near-record rates of quits and job vacancies, as well as a notable pickup in wage growth. In line with the recent data showing a rise in the employment cost index, many participants reported District business contacts either planning or having implemented larger wage increases to retain current employees or attract new workers. Participants generally noted that they were monitoring the incoming data for signs of inflationary pressures associated with the increasingly tight labor market. Acknowledging that the maximum level of employment consistent with price stability may evolve over time, many participants saw the U.S. economy making rapid progress toward the Committee’s maximum-employment goal. Several participants viewed labor market conditions as already largely consistent with maximum employment.

It won’t take much to declare victory on employment based on the three employment reports we will get between now and the March meeting. Barring a sharp change in the economic outlook, that victory clears the way for a March hike.

On inflation, there are no more dovish voices:

Participants remarked that inflation readings had been higher and were more persistent and widespread than previously anticipated. Some participants noted that trimmed mean measures of inflation had reached decade-high levels and that the percentage of product categories with substantial price increases continued to climb. While participants generally continued to anticipate that inflation would decline significantly over the course of 2022 as supply constraints eased, almost all stated that they had revised up their forecasts of inflation for 2022 notably, and many did so for 2023 as well. In discussing their revisions to the inflation outlook, participants pointed to rising housing costs and rents, more widespread wage growth driven by labor shortages, and more prolonged global supply-side frictions, which could be exacerbated by the emergence of the Omicron variant. Moreover, participants widely cited business contacts feeling confident that they would be able to pass on higher costs of labor and material to customers. Participants noted their continuing attention to the public’s concern about the sizable increase in the cost of living that had taken place this year and the associated burden on U.S. households, particularly those who had limited scope to pay higher prices for essential goods and services.

Apparently, there were no participants aggressively pushing the transitory story. That story is dead for now. The implication is that there is no resistance to a March rate hike on that basis. Moreover, it matches our view that the consensus has moved markedly in a hawkish direction and most likely any new personnel will fall in line with that consensus. Also note the reference to inflation as an equity issue. Interestingly, FOMC participants have abandoned the Fed staff’s forecast, at least for now. The Fed staff on inflation:

As a result, the 12-month change in PCE prices was projected to move up further relative to October’s pace and to end the year around 5 percent. Over the following two years, the boost to consumer prices caused by supply issues was expected to partly reverse, and energy prices were projected to decline. PCE price inflation was therefore expected to step down to 2.1 percent in 2022 and to remain there in 2023 and 2024. 

The Fed staff are still on Team Transitory, but FOMC participants have apparently recognized that despite the staff’s storied legacy, in this business you are only as good as your last call.

We have highlighted that decisions on the balance sheet are going to happen soon after rate hikes begin and FOMC participants confirm this. First, note that the Fed will soon be updating its policy normalization plans, probably at the January meeting:

Participants judged that several aspects of the previous approach remained applicable in the current environment. In particular, they noted that the principles and plans underlying policy normalization were communicated in advance of any decisions or actions, which enhanced the public’s understanding and thus the effectiveness of monetary policy during that period.

Like in the last cycle, the Fed expects to communicate that interest rates are the primary mechanism to communicate the Fed’s policy stance. There is not going to be a long lag between raising rates and QT:

Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience.

Not only will it come sooner, but it will likely be faster:

They noted that current conditions included a stronger economic outlook, higher inflation, and a larger balance sheet and thus could warrant a potentially faster pace of policy rate normalization.

There, however, is not much appetite for using QT to manage the shape of the yield curve:

Some participants commented that removing policy accommodation by relying more on balance sheet reduction and less on increases in the policy rate could help limit yield curve flattening during policy normalization. A few of these participants raised concerns that a relatively flat yield curve could adversely affect interest margins for some financial intermediaries, which may raise financial stability risks. However, a couple of other participants referenced staff analysis and previous experience in noting that many factors can affect longer-dated yields, making it difficult to judge how a different policy mix would affect the shape of the yield curve.

The Fed also began discussing the appropriate size of the balance sheet in the long run. Unfortunately, there is no good answer:

Several participants noted that the level of reserves that would ultimately be needed to implement monetary policy effectively is uncertain, because the underlying demand for reserves by banks is time varying.

That said, the creation of the Standing Repo Facility appears to be pushing FOMC participants in the direction of erring on the low side:

Some participants expressed the view that the SRF would help ensure interest rate control as the size of the balance sheet approached its longer-run level; several participants noted that the SRF could facilitate a faster runoff of the balance sheet than might otherwise be the case; several participants raised the possibility that the establishment of the SRF could reduce the demand for reserves in the longer run, suggesting that the longer-run balance sheet could be smaller than otherwise.

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.

Bottom Line: The pivot is complete with little resistance. The doves have long been assimilated into the new narrative. The game isn’t just about the first half of the year anymore. It’s time to start thinking about how the data flow impacts the narrative in the second half of the year.

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