Tim Duy’s Fed Watch, 12/13/21

Published on December 13, 2021
SGH Insight
The likely data highlight of the week comes Wednesday in the form of the retail sales report for November. Wall Street is expecting retail sales will moderate from 1.7% to a still strong 0.9% gain. Note that the Chicago Fed retail sales tracker predicts a more modest 0.4% gain.
Market Validation
Bloomberg 12/15/21

U.S. Nov. Retail Sales Rose 0.3%, Below Estimate

Retail sales less autos rose 0.3% in Nov., est. 0.9%

Monday Morning Notes, 12/13/21

If You Don’t Have Time This Morning

The FOMC is meeting for the first time since Chair Jerome Powell publicly pivoted the Fed in a hawkish direction. This is the first opportunity for the group to begin building a new consensus that shifts the focus from jobs to inflation. What exactly does that mean for policy? We know the Fed has turned hawkish, and the dot plot will reveal just how hawkish.

Recent Data and Events

Headline CPI came in a notch above expectations, rising 0.8% compared to 0.7% expected, while core CPI was exactly as expected with a 0.5% gain. The headline gain was the fastest annual increase since 1982 but on core it was only the highest since 1991:

As expected, rent and owner’s equivalent rent inflation moved higher:

These are less transitory sources of inflation although they occupy less weight in the PCE price measures. The Cleveland Fed median CPI measures eased somewhat on an annualized basis though they remain quite elevated:

Interestingly, on a year-over-year basis, core CPI is well above median CPI:

It’s typically the case that the median CPI overstates inflationary pressures relative to core-CPI. The current situation was more common prior to 1995. Potentially a signal that the underlying inflation dynamic is higher? Or just noise? Time will tell. In any event, Powell and others have identified such metrics as relevant to their assessment of whether or not inflation pressures are broadening.

Job openings rose while quits fell in October:

I wouldn’t read much into either change; both remain at historically high levels. The Beveridge curve remains shifted to the right:

This suggests substantial frictions remain in the labor market that are consistent with an elevated natural rate of unemployment. The gap between the number of job openings and the level of unemployment grew wider in October:

These two charts suggest to me that we are still at the early stages of wage pressures as these indicators are what would be expected deep into a cycle long after the Fed had begun raising rates.

Upcoming Data and Events

Some interesting data this week but nothing that is expected to change the underlying narrative of a booming economy. We get PPI inflation numbers Tuesday, but there is no straightforward overall relationship between producer and consumer prices. The likely data highlight of the week comes Wednesday in the form of the retail sales report for November. Wall Street is expecting retail sales will moderate from 1.7% to a still strong 0.9% gain. Note that the Chicago Fed retail sales tracker predicts a more modest 0.4% gain:

Thursday delivers housing starts data. Wall Street anticipates a modest increase in both starts and permits. Finally, on Thursday the Fed releases the industrial production numbers for November.

The FOMC meeting concludes on Wednesday. As of now, there are no scheduled Fed Speakers.

Day Release Wall Street Previous
Tuesday PPI, Final Demand, MoM, Nov. 0.5% 0.6%
Wednesday Retail Sales ex Auto, MoM, Nov. 0.9% 1.7%
Wednesday Retail Sales Control Group, MoM, Nov. 0.8% 1.6%
Thursday Housing Starts, Nov. 1570k 1520k
Thursday Building Permits, Nov. 1660k 1650k
Thursday Industrial Production, MoM, Nov. 0.7% 1.6%

Fed Speak and Discussion

The question for this week is not if the Fed will be hawkish. At this point, it is well understood that the Fed made a hard pivot toward hawkishness in recent weeks. The question is how hawkish will the Fed be? This is almost a whole new ballgame since Federal Reserve Chair Jerome Powell shifted the narrative and signaled that the just-begun tapering would be accelerated at this week’s meeting. Some market participants may have gotten ahead of the Fed and will be disappointed if the Fed does not validate an aggressively hawkish policy outlook.

I outlined my expectations for this meeting in notes last week. The Fed will accelerate the pace of tapering to $30 billion/month with the goal of ending asset purchases in March. The Fed will drop the “transitory” language from the statement. The dot plot will likely show two rate hikes in 2022, with the risks weighted toward more, and reveal an expected path of rates the brings rates to or just below neutral (2.5%) at the end of 2024. Powell will likely emphasize that this is not the same as tightening; rates for much if not the entire forecast horizon will still be below neutral.

In the press conference, Powell will follow the same path he took in his recent Congressional testimony. I think the narrative will be that sustaining the gains made in the labor market requires that the Fed maintains price stability which in turn requires an accelerated reduction of policy accommodation. Moreover, even if the Fed still fundamentally believes inflation pressures will ease as the year progresses, the upside risks to inflation while the economy approaches full employment changes the risk-reward calculation in favor of a less accommodative policy stance. At the last November press conference, Powell expressed confidence that inflation story will not become clear until the latter part of 2022, suggesting that the Fed wouldn’t consider hiking rates until at least the third quarter. The story at the Congressional testimony became:

So, the — our forecast — many — I’d say almost all forecasters do expect that inflation will be coming down meaningfully in the second half of next year. That’s an expectation. That’s the forecast. I think it’s likely, but I don’t think — I mean, the point is we can’t act as though we’re sure of that. We’re not at all sure of that. Inflation has been more persistent and higher than we’ve expected. And we have to use our policy to address the range of plausible outcomes, not just the most likely one, which is that one.

Powell has been burned by the staff forecast so badly this year I wonder why he is even willing to keep touching that stove at all. Still, at a minimum, he is certainly not taking that forecast as a certain outcome anymore and recognizes the need to pursue a different risk management strategy. This is especially the case because although much of the inflation will likely dissipate over the year, even persistent inflation in the 2.5-3% range would still be well above the Fed’s target. Moreover, unemployment falling to 4.2% dramatically changes the story. No longer does the Fed need to sacrifice the pursuit of full employment to maintain price stability. The goals are again aligned.

This is the Fed’s first meeting since the Powell policy pivot. Events moved quickly in the weeks after the November 2-3 meeting and FOMC participants have not had a chance to hash out the new narrative in a formal sit-down. I think this policy pivot has been largely driven from the top down and caught some FOMC participants by surprise. I suspect this explains Powell’s very clear public pivot; both because he was driving the story and he wanted to get that story out before the blackout period (which limited the ability of Fed officials to educate the public on the shift).

This week the Fed will need to consider when to declare victory on the inflation and employment mandates and open the door for a rate hike. I doubt they would declare such victory at this meeting. During his recent Congressional testimony Powell signaled that there was not yet a consensus on either mandate; in a response to Senator Krysten Sinema, he deferred an answer to anything about the employment mandate and said the inflation mandate issue would be decided in coming “meetings.” The use of the plural suggests more than one meeting. I don’t see that this sentence in the statement serves much purpose anymore:

With inflation having run persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent. 

At this point, all this sentence does is extend the implied lookback period in the Fed’s average inflation targeting framework. Moreover, it seems odd to say in a high inflation environment that inflation is running persistently below trend. This sentence could disappear without implications for the policy path.

The real challenge is that markets are clutching at straws with regards to the liftoff because the Fed’s guidance is so vague. As I have argued, with the unemployment rate falling to 4.2% and the inflation mandate essentially reached, the Fed can declare at any time that the conditions for a rate hike have been met. That said, I don’t think they have a consensus yet to make that move. Remember, they haven’t had a meeting since the pivot. My base case is another drop of the unemployment rate will force the Fed to open the door to a March rate hike (at the same time they could hard stop asset purchases as well, but I am not sure this buys them much and is potentially disruptive) but the Fed could declare victory on the inflation mandate this week and defer on the employment mandate until the next meeting. Alternatively, a possible adjustment to the language to signal further qualitative progress to the liftoff conditions but fall short of signaling a rate hike would be from this:

 In light of the substantial further progress the economy has made toward the Committee’s goals since last December, the Committee decided to begin reducing the monthly pace of its net asset purchases by $10 billion for Treasury securities and $5 billion for agency mortgage-backed securities.

To something along these lines:

With the economy on track to meet the Committee’s goals, the Committee decided to reduce the monthly pace of its net asset purchases by $20 billion for Treasury securities and $10 billion for agency mortgage-backed securities.

The market reaction to last week’s CPI report revealed that market participants may have outsized expectations of what to expect this week. The report revealed the highest inflation since 1982 yet treasuries rallied across the curve. Market participants were apparently positioned for even more hawkish numbers, and I sense something similar might be brewing for this week’s FOMC meeting. The Fed’s pivot was abrupt and caught many by surprise. It is not uncommon to overcompensate after such a surprise. During the last week, for instance, I have picked up chatter on an even more rapid pace of tapering and speculation of a 50bp rate hike in March. I don’t think Powell and his colleagues are ready to move us that far forward.

Still, the risks are weighted to the hawkish side this meeting. An obvious space for a hawkish surprise is the dots. As noted earlier, I expect the dot plot will reveal a median expectation of two hikes but with an upside risk for more. Arguing for more is obviously the Fed’s hawkish turn in response to the persistently elevated inflation numbers and the growing risk that the Fed is falling behind the curve. Arguing against more is that just prior to the blackout, St. Louis Federal Reserve President James Bullard reiterated his expectation for two rate hikes in 2022. If one of the more hawkish FOMC participants hasn’t bumped up his rate forecast, is it likely that the half of the participants that expected two rate hikes in 2022 will shift sufficiently upward to bring the median somewhere above two hikes? Seems like a stretch to me, leaving clustering around two hikes most likely with upside risk.

Finally, the political implications of high inflation are intensifying. Via the Financial Times:

Moderate Democrats are pushing the Federal Reserve to move more aggressively towards tighter monetary policy to stamp out inflation, in a sign of their mounting concern about the political fallout from high prices. The pressure on the US central bank from the centrist wing of the Democratic party has increased ahead of next week’s Federal Open Market Committee meeting, during which the Fed is expected to announce a more rapid drawdown of its asset purchases, setting the stage for possible interest rate increases later next year. 

I don’t think it is a coincidence the Fed pivoted in a hawkish direction after Powell’s and Brainard’s interviews for the Chair and Vice-Chair spots. Yes, I know the Fed isn’t supposed to take political issues into account when setting monetary policy (that’s the Fed’s party line and it will stick with it), but reality can be different. And this isn’t just about the White House or the Democrats. It’s hard to see that the political implications of high inflation wouldn’t blow back on the Fed eventually. For now, the Democrats are catching all the flack, but eventually someone will realize the Fed made a proactive choice to fully accommodate the last round of fiscal stimulus. Congress sets the fiscal priorities, but the Fed is supposed to help manage the macroeconomic consequences. Inflation is the Fed’s number one job, and if the Fed can’t get that right, how can it be trusted on issues like regulation, climate change, and equity? Simply put, persistent inflation is a threat to the institution’s integrity, and this should factor into the Fed’s risk management strategy.

Bottom Line

The Fed’s hawkish pivot leaves a lot of questions unanswered. We should start getting those answers this week.

Good luck and stay safe this week!

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