Tim Duy’s Fed Watch, 11/29/21

Published on November 29, 2021
SGH Insight
Bottom Line
This has the potential to be a fast-moving situation, so uncertainty is once again elevated. Still, at this point I think the most likely path forward is that the Fed accelerates tapering at the next meeting to $30 billion/month. This would both begin to adjust policy to account for supply side nature of shocks and allow the Fed to retain the optionality to hike earlier than June. This would be prudent risk management. I suspect we will see the Fed’s narrative evolve to the effect that there is growing tension between the Fed’s employment and inflation mandate such that the Fed needs to tilt policy a notch toward the latter. They can fit the likely impact of the new variant into such a narrative.
Market Validation
Policy validation

Bloomberg 11/30/21

Powell Says Appropriate to Weigh Earlier End to Bond-Buy Tapering

Federal Reserve Chair Jerome Powell said it’s appropriate to consider finishing the central bank’s tapering of asset purchases a few months earlier than previously expected, with inflation proving more persistent than forecast.
Powell made the comment in response to questions during a Senate Banking Committee hearing in Washington.
The Fed is currently scheduled to complete its asset-purchase program in mid-2022.

Market Validation

Bloomberg 11/30/21

Traders Amp Up Fed Hike Bets on Powell, Driving Curve Flatter
Powell comments fuel advance in short-end Treasury yields
Eurodollar markets now pricing in more tightening for 2022

Traders boosted bets on the pace of Federal Reserve policy
tightening, pushing the Treasury yield curve to its flattest level since January,
after comments by Chair Jerome Powell on the prospects for faster asset-
purchase tapering.
The premium of the 10-year rate over the 2-year yield dropped as much as 8.8
basis points to 92.2 basis points as Powell, testifying before Congress, said the
central bank can consider wrapping up tapering a few months sooner.
The 2-year rate climbed as much as 8.5 basis points to 0.57%, and its high for
the day was around 14 basis points above the intraday low. 
Eurodollar markets now show around 57 basis points of hikes -- more than two
standard quarter-point increases -- priced in by the end of 2022. They had been showing closer to 50 basis points at the close of trading Monday.

Monday Morning Notes, 11/29/21

If You Don’t Have Time This Morning

The Omicron variant roiled markets last week but we have only much speculation and few hard facts. The Fed will likely press forward with the policy pivot and continue making the case for a faster pace of tapering but remind us that policy will respond to new variants as needed. Watch for the Fed to note that successive waves of Covid are shocks that intensify inflationary pressures.

Recent Data and Events

The big news over the weekend was the identification of a new Covid variant, Omicron. See my thoughts on that and Fed policy below.

Never bet against the consumer. If there is job growth, there is spending growth. Household spending surged in October, rising 1.3% and 0.7% in nominal and real terms, respectively. Nominal spending is a path well above pre-pandemic trends, while in real terms spending is back to trend:

The hypothesized shifts from goods to services spending remains just that, a hypothesis. The reality is that while services spending continues to rise, goods spending powered forward to a record high:

The Fed has pinned its hopes on the assumption that as the pandemic eased, consumption patterns would normalize and solve its inflation problems. The problem with that theory is that nominal wages keep growing at a pace that supports more spending on both goods and services:

Over that past three months, wages and salaries grew at a roughly 9% annualized pace. The math on this is impossible to ignore. At 2% inflation, the economy needs to produce 7% more stuff to meet that spending power. That’s not happening, and what doesn’t show up in quantities will instead show up in prices. This isn’t rocket science. If inflation is going to slow, wage and salary growth needs to moderate. That’s what I am watching for.

Speaking of prices, core-PCE inflation accelerated to a 5.2% annualized rate in October, up 4.1% from a year ago:

 Note that the sharp drop in oil prices over the weekend may fuel a disinflationary narrative. If sustained, it will help weigh on headline inflation; I would be wary of trying to fight that narrative near term. That said, I don’t think oil/gas is the right inflationary narrative. The focus should be on core inflation. I think politicians and the media have learned to assume that every rise in household inflation expectations is the sole result of gas prices. I don’t think that’s the story here. Consumers see a wide array of price increases. Nor are supply chain problems the story. That story was an ad hoc ex post rationalization for a forecast error. As regular readers know, I take a top-down perspective. The recent pace of wage and salary growth is simply inconsistent with 2% inflation. Along those lines, note that Social Security payments are indexed to inflation and will rise 5.9% in January, extra income to keep the party going.

Meanwhile, consumers increasingly view inflation as something more than a transitory nuisance. Michigan consumer sentiment sank in November to 67.4, the lowest in the past decade. To be sure, the intensification of political partisanship warps the numbers, but sentiment has fallen across all political affiliations. The survey’s chief economist, Richard Curtin, attributes the decline to inflation:

Consumers expressed less optimism in the November 2021 survey than any other time in the past decade about prospects for their own finances as well as for the overall economy. The decline was due to a combination of rapidly escalating inflation combined with the absence of federal policies that would effectively redress the inflationary damage to household budgets. While pandemic induced supply-line shortages were the precipitating cause, the roots of inflation have grown and spread more broadly across the economy. One-in-four consumers cited inflationary erosions of their living standards in November.

Curtain expects that consumers will demand a government response in the form of more spending power like that for seniors as noted above:

Moreover, a protracted inflationary period will bring a renewed urgency for expanding government relief payments from job losses to cover inflationary declines in living standards.

 Interestingly, Republicans in Illinois have announced just such a proposal. We should keep an eye on this trend; you can’t fight inflation with more spending, but that doesn’t mean politicians won’t try.

A final important point on this topic is that although consumers report that this is a terrible time to buy things like houses, cars, and durable goods, they are still buying those things. Inflation is making people unhappy because their real spending power is eroding but they still have the nominal income gains to keep spending despite higher inflation. In fact, those income gains are the cause of higher inflation.

Upcoming Data and Events

It’s the typically busy first week of the month. Monday and Tuesday we get updates on the housing market with pending home sales and Case-Shiller housing prices, respectively. The general expectation is that we see the housing market remains on solid ground; note that faster income growth helps underpin higher rent and home prices. On Wednesday we see manufacturing data from ISM and Markit, both of which will likely tell a familiar tale of intense price pressures amid strong demand. Their service sector counterparts will be released Friday. Also Wednesday we get the ADP employment numbers which are expected to show a gain of 515k private sector employees.

The biggest day of the week is Friday. Wall Street expects the employment report will reveal the economy added 525k jobs in November with the unemployment rate edging down to 4.5%. Optimally, the Fed would like to see a pick-up in labor force participation, but I don’t think that would be a deterrent to faster tapering. The Fed has probably pushed the “waiting for labor supply to recover” story as hard as it can; inflation is now taking a central role in the narrative. As always, watch aggregate weekly payrolls as it tells us something about nominal spending power and by extension the degree of inflation pressures.

There will be plenty of Fed speak this week, much of it not directly focused on current monetary policy. Williams and Powell (pre-recorded) will make remarks at the opening of the NY Innovation Center, Powell and Yellen will be on Capitol Hill testifying on the CARES act, Bowman will discuss central banking and indigenous economies, and Clarida will discuss Fed independence. Bullard, Bostic, Barkin, and Daly, however, will all be in venues in which we would expect them to provide policy guidance. I am particularly interested in Quarles’ speech on Thursday in which he gives his departing thoughts. Of course, these are all opportunities to learn how the Fed is thinking about the Omicron variant. I expect a lot of “stay the course but be prepared to respond as needed” type of commentary. Finally, the latest Beige Book is released Wednesday.

Day Release Wall Street Previous
Monday Pending Home Sales, MoM, Oct. 0.7% -2.3%
Tuesday Case-Shiller Home Prices, MoM, Sep. 1.25% 1.0%
Wednesday Markit US Manufacturing PMI, Nov. F 59.1
Wednesday ISM Manufacturing, Nov. 61.0 60.8
Wednesday ADP Employment, Nov. 515k 571k
Thursday Initial Unemployment Claims 255k 199k
Friday Unemployment Rate, Nov. 4.5% 4.6%
Friday Nonfarm Payrolls, Nov. 525k 531k
Friday Average Weekly Earnings, MoM, Nov. 0.4% 0.4%
Friday Markit US Services PMI, Nov. F 57.0
Friday ISM Services, Nov. 65.0 66.7

Fed Speak and Discussion

Going into this past weekend, focus had turned to an accelerated Fed tapering schedule. Fed speak had clearly shifted in a hawkish direction and made clear that the pace of tapering would be a topic of conversation at the December FOMC meeting. If there were any remaining questions that a Fed pivot was in progress, San Francisco Federal Reserve President Mary Daly’s hawkish turn made clear the direction. Via Yahoo! Finance:

Well, I certainly see a case to be made for speeding it up. We have two important data points that are going to come in before the next meeting, and will really inform my take, our deliberations, and certainly my thoughts. Those are another report on the labor market — another jobs report — and also another report for the CPI. And if things continue to do what they’ve been doing, then I would completely support an accelerated pace of tapering.

Just two weeks earlier she argued for a long period of patience:

Over the next several quarters, as tapering occurs, we will watch to see how the economy does and whether inflation eases and workers come back. As we get a clearer signal, we will be ready to act, continuing to provide or remove support as needed to ensure the economy settles at a sustainable place.

A complete turnaround on Daly’s part reflective of the reality that the consensus position had shifted dramatically after the most recent CPI numbers. The political reality is settling in at the Fed. The public sees abundant help wanted signs with inflation broadening out. It turns out that during those Fed Listens events, people weren’t worried about inflation because they hadn’t seen it since 1991. Now that they see it, they don’t like it, and with job openings through the roof, people aren’t buying the weak job market story. The White House clearly doesn’t like it either, and this was almost certainly communicated to Federal Reserve Chair Jerome Powell and Governor Lael Brainard at their recent interviews for the chair and vice-chair positions.

As I expected, the hawkish round of Fed speak foreshadowed the FOMC minutes. In November, meeting participants agreed to taper asset purchases with the usual caveat that tapering had nothing to do with rate hikes:

Participants noted that beginning to scale back the pace of net asset purchases was not intended to convey any direct signal regarding adjustments to the target range for the federal funds rate. They highlighted the more stringent criteria for raising the target range, compared with the criteria that applied to beginning to reduce the pace of asset purchases.

This separation is impossible, however, because tapering precedes rate hikes. If the Fed sees a risk it needs to pull forward rate hikes, it needs to taper faster. Indeed, this point is made in literally the next paragraph of the minutes:

Participants stressed that maintaining flexibility to implement appropriate policy adjustments on the basis of risk-management considerations should be a guiding principle in conducting policy in the current highly uncertain environment. Some participants suggested that reducing the pace of net asset purchases by more than $15 billion each month could be warranted so that the Committee would be in a better position to make adjustments to the target range for the federal funds rate, particularly in light of inflation pressures. Various participants noted that the Committee should be prepared to adjust the pace of asset purchases and raise the target range for the federal funds rate sooner than participants currently anticipated if inflation continued to run higher than levels consistent with the Committee’s objectives. 

To suddenly shift to accelerated tapering means that in the span of just a couple of weeks the Fed not only pulled expected rate hikes forward to the middle of 2022 but then became sufficiently worried about inflation that it needed to open up additional room to raise rates sooner than June should it be needed. That’s a hard pivot. The Fed had as recently as the November FOMC meeting thought it had plenty of time to pull forward rate hikes even with tapering not expected to conclude until the middle of 2022. Remember, in September only half of FOMC participants thought a rate hike was likely in 2022. Still, clearly a group of Fed hawks were pushing hard for a faster taper and were primed to push even harder if the inflation outlook worsened. It did, and along with the October jobs report and the spending data, the Fed doves lost the high ground.

The new Omicron variant, however, adds a fresh dimension to the Fed’s current policy dilemma. During a thinly traded and shortened holiday session last Friday, markets were roiled by the news. It was a classic risk-off event with stocks falling sharply while bonds surged. The yield on the 10-year Treasury sank 16 basis points to 1.48% and traders priced out one of the expected rate hikes in 2022. At this point, we do not know enough about the new variant to assess its ultimate impact. Early speculation suggests it is more transmissible and more likely to escape existing vaccines than earlier variants, but more data is needed. We also don’t know yet if it is more or less severe than existing variants, but initial reports are hopeful. Via Bloomberg:

While South Africa, which first identified the new variant, currently has 3,220 people with the coronavirus infection overall, there’s been no real uptick in hospitalizations, Barry Schoub, chairman of the Ministerial Advisory Committee on Vaccines, told Sky News on Sunday.

“The cases that have occurred so far have all been mild cases, mild-to-moderate cases and that’s a good sign,” said Schoub, adding that it was still early days and nothing was certain yet…

…The large number of mutations found in the omicron variant appears to destabilize the virus, which might make it less “fit” than the dominant delta strain, said Schoub. “

In a way, hopefully it won’t displace delta because delta we know responds very well to the vaccine,” he said.

Only about a third of South Africans are vaccinated.

While many countries including the U.S. enacted fresh travel bans to some African nations, I think we should expect to learn that it has already been circulating; once other nations start looking for it, I bet they find it (cases have already been identified in the U.K., Hong Kong, Italy, Belgium, and probably more by the time you read this). We will be getting new information, either positive or negative, over the coming weeks. On the plus side, vaccine manufactures are confident they can retool existing vaccines to target the new variant. Pfizer believes it would take about 3 months to begin shipping new vaccines. Watch too for the new vaccine from Novavax. The company reports that it will only take a few weeks to test and begin manufacturing a new shot.

The November FOMC minutes tell us some participants were already thinking about new variants. It’s complicated:

A few participants mentioned an upsurge in COVID-19 cases during the coming winter or an emergence of new virus strains as possibilities that, if they were realized, would damp economic activity and intensify price pressures.

In other words, successive waves of Covid are primarily negative supply shocks, a reality the Fed is going to have to come to terms with sooner or later. Covid is not just “going away.” It is endemic and until we get a next generation of Covid vaccines to provide broader and longer lasting immunity, we will face successive waves as the virus mutates. That, at least, is my base case. The evidence so far suggests that we can’t vaccinate quickly enough to eliminate variants; endemic is the new normal and eventually we will need monetary policy to adjust accordingly. The Fed will need to find a new policy approach; the strategy of automatically easing into successive supply shocks isn’t keeping inflation contained.

The first Fed speaker to address the Omicron variant was Atlanta Federal Reserve President Raphael Bostic. He maintained the policy narrative established last week. Via Bloomberg:

“I am very open to accelerating the pace of our slowdown in purchases,” Bostic, a voter this year on the policy-setting Federal Open Market Committee, told Fox News in an interview Friday. “For me, early second quarter, late first quarter of 2022 are all in play as reasonable alternatives for when we might stop our purchases if the economy’s momentum continues as it has over the last several months.”

To be sure, Bostic notes that he is assuming new variants follow the same pattern in that each successive wave has less of an impact than prior waves. Still, he says that the longer the pandemic is with us, the longer the price pressures will remain:

Bostic said he expects price pressures to fade as supply disruptions caused by the pandemic ease toward the middle of next year. But there is a lot of uncertainty and the new variant could prolong that process of adjustment.

“The longer this goes on, the longer we’re going to have elevated inflation and the sooner we may need to act,” he said. “We’re going to let the economy and the data that come in really inform how we approach our interest-rate policy, as well as our tapering policy. And we’ll be ready. We’re not going to let inflation get out of control.”

Essentially, Bostic is concluding that successive waves of the pandemic call for tighter monetary policy, not the repeatedly looser response the Fed has adopted since the beginning of the pandemic. Watch to see if other speakers follow Bostic. He, like St. Louis Federal Reserve President James Bullard, has tended to be hawkishly ahead of the curve this year.

Bottom Line

This has the potential to be a fast-moving situation, so uncertainty is once again elevated. Still, at this point I think the most likely path forward is that the Fed accelerates tapering at the next meeting to $30 billion/month. This would both begin to adjust policy to account for supply side nature of shocks and allow the Fed to retain the optionality to hike earlier than June. This would be prudent risk management. I suspect we will see the Fed’s narrative evolve to the effect that there is growing tension between the Fed’s employment and inflation mandate such that the Fed needs to tilt policy a notch toward the latter. They can fit the likely impact of the new variant into such a narrative. Of course, I will be carefully watching Fed speak this week to see if the Fed pivots back to where it was two weeks ago. They may shift back, but I don’t think they can afford the risk that the next wave of Covid is like the last where inflation intensifies, and they haven’t adjusted policy accordingly.

Good luck and stay safe this week!

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