Tim Duy’s Fed Watch, 11/16/21

Published on November 16, 2021
SGH Insight
Bottom Line: The economy is gaining steam in the fourth quarter while inflationary pressures remain elevated. That’s a mix that will push the Fed in a hawkish direction. Watch for the consensus to drift as Bullard suggests, toward starting to lay the groundwork that would allow a policy pivot that accelerates tapering or even pulls rate hikes earlier in 2022. Discount the doves as the Fed has been pulled in the direction of hawkish Presidents because the data runs in a hawkish direction. Places to watch include warnings about high inflation and reassessments of what constitutes full employment.
Market Validation
Policy Validation

Bloomberg 11/19/21

The Federal Reserve looks on course to
consider a more rapid drawdown of its mammoth bond-buying
program just weeks after it instituted a plan to scale the
purchases back in a methodical manner.
A trio of policy makers -- Vice Chairman Richard Clarida,
Governor Christopher Waller and St. Louis Federal Reserve Bank
President James Bullard -- signaled this week that the topic of
a faster taper might be on the table when the Federal Open
Market Committee meets Dec. 14-15.

Retail Sales, Fed Speakers at Opposite Ends of the Policy Spectrum

 

Retail sales surprised on the upside with the ex-autos category gaining 1.7% compared to an expected 1.0%. As I noted Monday, inflation and the Chicago Fed numbers foreshadowed an upside miss to consensus forecasts. Sales in the control group continue to climb higher:

The important point for us is that the Fed continues to assume that goods spending must fall so that services spending can rise, and that adjustment will relieve inflationary pressure in the economy. So far, nominal goods spending stubbornly refuses to cooperate. As regular readers know, my position is that wage and salary growth is more than sufficient to sustain spending on goods and keep pushing service spending higher. The mix can move toward services spending without a decline in goods spending.

Meanwhile, St. Louis Federal Reserve President James Bullard said the Fed should continue its hawkish drift. Via Bloomberg:

“I think it behooves the committee to go in a more hawkish direction in the next couple of meetings so we are managing the risk of inflation appropriately,” Bullard, who votes on monetary policy in 2022

Bullard offers three options to address inflation pressures, end the taper early, let the balance sheet runoff after tapering, and raise rates before tapering is complete. By moving in a more hawkish direction over the next couple of meetings, the Fed would be positioning itself to make such a hard pivot at the March meeting if needed. Right now, it’s tough for me to see a pivot before March given that general consensus that the Fed won’t know the real inflation story until the second or third quarters of next year. Seems like January would be too early to undermine confidence in the prediction entirely but clearly this is something I am watching for. The Fed’s traditional behavior at turning points is deny, deny, deny, then shift.

In contrast, San Francisco Federal Reserve President Mary Daly argues that monetary policy to slow the economy is at best ineffective to curb current inflation and possibly harmful:

Monetary policy is a blunt tool that acts with a considerable lag. So, raising interest rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers.

She argues against pre-emptive rate hikes:

Against this calculus, I come down on the side of waiting to gain greater clarity. The Fed is well positioned to act should inflation begin to look more persistent. It’s much harder to unwind a preemptive action that turns out to be wrong.

A couple of thoughts. First, note that the Fed isn’t focused on an imminent rate hike. Bullard isn’t suggesting that the Fed hikes rates in December, but instead wants to position the Fed to shift in a hawkish direction next year should it be necessary (although I suspect he thinks it will likely be necessary).

Second, if policy acts with a considerable lag as Daly says, and the Fed is still adding accommodation into the middle of next year, the stimulative impact won’t reach its maximum until the middle of 2023 or later. In other words, monetary policy continues to run virtually flat out into an inflationary surge with the economy approaching full employment and the impact won’t be fully felt until we are past full employment. Adjust your forecasts accordingly.

Third, although Daly describes rate hikes as “preemptive” at this point, policy is way, way past anything that can be called preemptive. Preemptive was the last cycle, when the Fed began tapering when the unemployment rate was 6.7% and hiking rates at 5.0%. The economy is at 4.6% unemployment now and the Fed is just starting to taper. I don’t think policy is in any way well positioned to act if inflation is more persistent. Those lags Daly talks about cut both ways; if inflation is stubbornly persistent and works its way more obviously into wages, the Fed will be forced to choose between rapidly hiking rates to compensate for the lags and flirting with recession or letting inflation go. Policy is positioned only for things to go “right” in the sense that inflation follows the script that it has so far failed to follow. I don’t think there is much if any middle ground left.

Bottom Line: The economy is gaining steam in the fourth quarter while inflationary pressures remain elevated. That’s a mix that will push the Fed in a hawkish direction. Watch for the consensus to drift as Bullard suggests, toward starting to lay the groundwork that would allow a policy pivot that accelerates tapering or even pulls rate hikes earlier in 2022. Discount the doves as the Fed has been pulled in the direction of hawkish Presidents because the data runs in a hawkish direction. Places to watch include warnings about high inflation and reassessments of what constitutes full employment.

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