Last Minute Thoughts Heading into the FOMC Meeting
We are now less than 24 hours away from the final FOMC meeting of 2021, one that is expected to “operationalize” Chair Jerome Powell’s hawkish policy pivot. There is an elevated level of uncertainty surrounding the outcomes of this meeting and I don’t think it serves us any purpose to pretend otherwise.
Powell shifted his rhetoric to “would act” if inflation were to become a concern to “will act” to prevent inflation from becoming entrenched. That shift implies that inflation is now a concern. It can no longer be ignored as a “transitory” deviation with no material relevance for policy. This holds even if the Fed remains attached to the “transitory” view at a fundamental level. The risks are clearly weighted in the direction of the higher inflation while the drop in the unemployment rate to 4.2% means the economy is closer to full employment.
Policy must adjust accordingly, but what exactly does that mean? At minimum, the Fed’s pivot will be immediately operationalized in an acceleration of tapering. The Fed will also raise the expected path of policy rates such that participants expect two rate hikes in 2022 with a risk of more. The Fed will adjust language in the FOMC statement to remove “transitory” and may also signal the economy has made “further progress towards” or is “on track to meet” the Fed’s goals.
Beyond those outcomes, however, market participants are focused on Powell’s messaging regarding the vulnerability of the expected rate path. An SEP forecast of two rate hikes suggests a June liftoff while markets are pricing in a 40% change of a March liftoff. What would Powell say about these odds? I think Powell will want to retain maximum flexibility. In this case, I think that means he will not want to embrace current market pricing for a March rate hike, but he won’t want to push back on it either. Given how rapidly the Fed shifted gears between the November and December FOMC meetings, it seems Powell would be making a misstep to rule out March. At the same time, if he appeared to embrace a March hike, he would be sending a signal ahead of the data. I think that would be a mistake given the possibility of Omicron-related disruptions. I think the basic story he will want to push is that with the balance of risk tilted toward inflation, the Fed will act to prevent inflation from becoming entrenched, which should be interpreted as every meeting is now “live.” September, November, and now December, were all “live” for policy change, and we should expect January will be as well.
Some additional thoughts:
1. Will Powell continue to endorse the illusion that tapering has no implications for rate hikes? The criteria for tapering have obviously already been met and the debate has now shifted to the criteria for rate hikes. Tapering is only being accelerated because the economy is closer to meeting the criteria for rate hikes. It’s impossible to really believe otherwise, especially since the last minutes confirm this point:
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.
The only reason to accelerate the taper is because the Fed sees a risk it might need to hike rates before June. Time to just own that.
2. Has the Fed accepted it is time to consider rate hikes? Following from the above point, if the Fed is accelerating tapering to bring forward rate hikes, it must follow that it is soon time to think about rate hikes. Likewise, if the Fed is actively debating if the criteria for rate hikes have been met, then it must also follow that it is soon time to talk about rate hikes. At some point soon, and it should be tomorrow, the Fed needs to come clean and say that if inflation is a concern like it says, then it must be time to talk about rate hikes.
3. Has the Fed’s reaction function changed? I see commentary to the effect that the Fed’s pivot reflects a change in the reaction function. I disagree; I think the Fed is primarily responding to incoming data (although I think the Fed got a push from the White House to remember that policy is supposed to be outcome-based and the inflation outcomes are not good). Either way, I am watching for Powell to clarify this point. Note that within the context of “flexible” average inflation targeting, a range of policy moves might be considered consistent with the Fed’s inflation target.
4. Finally, and what might be the most important issue, is the signaling about the policy intent with respect to economic outcomes. What I think strikes fear in the hearts of equity investors and helps keep downward pressure on long yields is the idea that the hawkish pivot implies the Fed is preparing to drive growth substantially lower. I don’t think this is true, and I think Powell will emphasize it is not true. I think the message will be that if the Fed needs to hike rates earlier than expected, the intention will be to moderate growth to maintain price stability and extend the expansion. A key point in the pivot is that the Fed wants to maintain progress in the labor market. That progress requires price stability. In turn, policy needs to become less accommodative in order to maintain price stability and allow for continued job growth. In this framework, delaying rate hikes is the threat to the expansion because of the risk of entrenched inflation. It’s that delay that would force the Fed to hike rates to the point that it risks a recession. (Note, however, that equity markets might still be challenged even if the economy just comes off the boil.)
That’s it, some last-minute thoughts generated by client contacts over the past couple of days. Good luck tomorrow.