Tim Duy’s Fed Watch, 12/16/21

Published on December 16, 2021
SGH Insight
Additional Thoughts on the Fed Pivot

Last night at dinner I gave my daughter the choice of either reviewing the latest issue of Fine Woodworking magazine or working through the SEP projections and re-watching Powell’s press conference. She chose the latter (kids these days, right?). Between that review, questions from clients overnight, and some other chatter that has crossed my desk, I have some additional thoughts on the results of the FOMC meeting.

Last night’s note had a short-term focus, primarily on the timing of the first rate hike. I think Powell set the stage for a March hike. The bar for a hike is pretty low at this point, just getting the Fed to reach consensus on full employment. That might sound like a big hurdle but note how many times Powell emphasized “rapid progress toward maximum employment.” We are not talking about “ground to cover” anymore. And, critically, note the absence of this line from the November press conference:

"The unemployment rate was 4.8 percent in September. This figure understates the shortfall in employment,
particularly as participation in the labor market remains subdued."

That second line isn’t in the December press conference. Why not? There is no hidden unemployment anymore now that the Fed views labor force participation as a lagging indicator. The unemployment rate is now taken at face value and the current 4.2% is just a hair over the Fed’s longer run projection of 4%. The Fed can and will dress up the full employment story with all sorts of labor market indicators, but the short version is that the economy is right on top of it already.

The Fed has plenty of time to telegraph a March rate hike. The January statement can clear the way for a rate hike and declare full employment or an expectation to meet full employment by March barring an Omicron disaster. In addition, we will have the Humphery-Hawkins testimony and even Powell’s confirmation hearings to bring everyone up to speed. Plenty of opportunities to get the word out. Powell made clear that tapering would be complete by the time of the March meeting, and any time after asset purchases end the Fed can hike. And this from Powell is about as close as he can get to autopilot without outright saying “March”:

"…so we've been calling out the fact that those were becoming longer and more persistent and larger and now
we're in a position where we're ending our taper within the next, well, by March, in two meetings and we'll be in a
position to raise interest rates as and when we think it's appropriate and we will, to the extent that's appropriate."

Because of Omicron, the debate is March versus May. If Omicron wasn’t a concern, then it would be March. And Omicron might not warrant any delay at all – see today’s move by the Bank of England.

Importantly, note that the Fed has repeatedly surprised on the hawkish side since June, so a March hike absolutely must be in play. The June dots, pulling forward the taper into 2021, the September dots, the September validation of a November taper, the acceleration of the taper, the December dots, and I think Powell all-but-validated a March hike yesterday, which I didn’t expect. Simply put, I have been on the hawkish leading edge of the curve for months and yet the Fed has still been a notch ahead of me. And, to Powell’s credit, that hawkish evolution has been accepted by the markets without disruption.

I expect the Fed will begin unwinding the balance sheet soon after rate hikes commence. That said, the Fed has just begun to struggle with this topic. Back to Powell:

"So, you know, with the balance sheet, we did have a balance sheet discussion as sort of a first discussion of
balance sheet issues today at our meeting this week. We'll have another at the next meeting and another at the
meeting after that, I suspect. These are interesting issues to discuss. Didn't make any decisions today. We
looked back at what happened in the last cycle and people thought that was interesting and informative, and
but to one degree or another people noted that this is just a different situation, and those differences should
inform the decisions we make about the balance sheet this time so haven't made any decisions at all about
when runoff would start but we'll be continuing to, in relation to when either liftoff happens or the end of the
taper but those are exactly the situations we'll be turning to in coming meetings."

The first key takeaway in that paragraph is that the last cycle is at best only a rough guide to how the Fed will manage the balance sheet this cycle. The second key takeaway is that the Fed will be considering options in the next few meetings (end of taper or liftoff). The primary difference between this cycle and the last is the strength of the rebound. As such, the Fed isn’t going to wait nearly two years after the first rate hike before it begins reducing the balance sheet. More likely is that it will happen soon after the first rate hike, within 6 months at the most. Arguably, that comparison with the last cycle also argues for a faster unwind as well.

Finally, thinking about how this year evolves, have we reached “peak hawkishness?” I think the key is the 2.7% core inflation forecast for 2022. That feels to me like the Fed is trying to get ahead of the inflation numbers after being behind all year. In other words, the Fed might think that between that forecast and the three rate hikes, it won’t have to get more hawkish in 2022. But why not just go all the way and predict four hikes if there is a high likelihood the Fed will go in March? First, going from zero to four hikes when the market anticipates two would risk sending a message that the Fed was so far behind the curve it needed to shift to a restrictive policy more quickly. Second, three hikes leaves open the possibility of using one quarter to initiate quantitative tightening (this would follow the 2017 playbook), so they already have four policy moves in mind for 2022. That leaves open the possibility of a March rate hike yet still holding the 2022 dots at three.

For the Fed to get more hawkish early in the year, we should be looking for signs that the inflation forecast is already in jeopardy. Remember, there is a widely held expectation that the Fed will get helped by the base effects pulling inflation lower after the first quarter. I would be cautious here as the Fed should look through the base effects to the monthly numbers; the Fed should clarify this distinction. The Fed could be waiting for that inflation decline before becoming more hawkish. So, my advice is to watch the month-over-month inflation numbers. The second thing to be watching is wages. The Fed is betting that wage pressures don’t intensify (note that Powell talked about wages as a signal of tightness in the labor market). That’s an obvious implication of the sustained 3.5% unemployment forecast starting next year in the context of declining inflation throughout the forecast horizon. If wage pressures become more obvious or it looks like unemployment will be sinking below 3.5% by the end of the year, the Fed will turn more hawkish. Third, of course, is watching measures of long-term inflation expectations.

That’s all for today. A lot to process after a busy week.
Market Validation
Policy Validation

Bloomberg 12/17/21

*WALLER: NO NEED TO DELAY BALANCE SHEET ADJUSTMENT
*WALLER: CAN START BALANCE SHEET SHRINKING SOONER AFTER LIFTOFF
*WALLER: CAN START B/S RUNOFF WITHIN ONE/TWO MEETINGS OF LIFTOFF
*WALLER FAVORS STARTING TO SHRINK BALANCE SHEET BY EARLY SUMMER

Additional Thoughts on the Fed Pivot

Last night at dinner I gave my daughter the choice of either reviewing the latest issue of Fine Woodworking magazine or working through the SEP projections and re-watching Powell’s press conference. She chose the latter (kids these days, right?). Between that review, questions from clients overnight, and some other chatter that has crossed my desk, I have some additional thoughts on the results of the FOMC meeting.

Last night’s note had a short-term focus, primarily on the timing of the first rate hike. I think Powell set the stage for a March hike. The bar for a hike is pretty low at this point, just getting the Fed to reach consensus on full employment. That might sound like a big hurdle but note how many times Powell emphasized “rapid progress toward maximum employment.” We are not talking about “ground to cover” anymore. And, critically, note the absence of this line from the November press conference:

The unemployment rate was 4.8 percent in September. This figure understates the shortfall in employment, particularly as participation in the labor market remains subdued.

That second line isn’t in the December press conference. Why not? There is no hidden unemployment anymore now that the Fed views labor force participation as a lagging indicator. The unemployment rate is now taken at face value and the current 4.2% is just a hair over the Fed’s longer run projection of 4%. The Fed can and will dress up the full employment story with all sorts of labor market indicators, but the short version is that the economy is right on top of it already.

The Fed has plenty of time to telegraph a March rate hike. The January statement can clear the way for a rate hike and declare full employment or an expectation to meet full employment by March barring an Omicron disaster. In addition, we will have the Humphery-Hawkins testimony and even Powell’s confirmation hearings to bring everyone up to speed. Plenty of opportunities to get the word out. Powell made clear that tapering would be complete by the time of the March meeting, and any time after asset purchases end the Fed can hike. And this from Powell is about as close as he can get to autopilot without outright saying “March”:

…so we’ve been calling out the fact that those were becoming longer and more persistent and larger and now we’re in a position where we’re ending our taper within the next, well, by March, in two meetings and we’ll be in a position to raise interest rates as and when we think it’s appropriate and we will, to the extent that’s appropriate.

Because of Omicron, the debate is March versus May. If Omicron wasn’t a concern, then it would be March. And Omicron might not warrant any delay at all – see today’s move by the Bank of England.

Importantly, note that the Fed has repeatedly surprised on the hawkish side since June, so a March hike absolutely must be in play. The June dots, pulling forward the taper into 2021, the September dots, the September validation of a November taper, the acceleration of the taper, the December dots, and I think Powell all-but-validated a March hike yesterday, which I didn’t expect. Simply put, I have been on the hawkish leading edge of the curve for months and yet the Fed has still been a notch ahead of me. And, to Powell’s credit, that hawkish evolution has been accepted by the markets without disruption.

I expect the Fed will begin unwinding the balance sheet soon after rate hikes commence. That said, the Fed has just begun to struggle with this topic. Back to Powell:

So, you know, with the balance sheet, we did have a balance sheet discussion as sort of a first discussion of balance sheet issues today at our meeting this week. We’ll have another at the next meeting and another at the meeting after that, I suspect. These are interesting issues to discuss. Didn’t make any decisions today. We looked back at what happened in the last cycle and people thought that was interesting and informative, and but to one degree or another people noted that this is just a different situation, and those differences should inform the decisions we make about the balance sheet this time so haven’t made any decisions at all about when runoff would start but we’ll be continuing to, in relation to when either liftoff happens or the end of the taper but those are exactly the situations we’ll be turning to in coming meetings.

The first key takeaway in that paragraph is that the last cycle is at best only a rough guide to how the Fed will manage the balance sheet this cycle. The second key takeaway is that the Fed will be considering options in the next few meetings (end of taper or liftoff). The primary difference between this cycle and the last is the strength of the rebound. As such, the Fed isn’t going to wait nearly two years after the first rate hike before it begins reducing the balance sheet. More likely is that it will happen soon after the first rate hike, within 6 months at the most. Arguably, that comparison with the last cycle also argues for a faster unwind as well.

Finally, thinking about how this year evolves, have we reached “peak hawkishness?” I think the key is the 2.7% core inflation forecast for 2022. That feels to me like the Fed is trying to get ahead of the inflation numbers after being behind all year. In other words, the Fed might think that between that forecast and the three rate hikes, it won’t have to get more hawkish in 2022. But why not just go all the way and predict four hikes if there is a high likelihood the Fed will go in March? First, going from zero to four hikes when the market anticipates two would risk sending a message that the Fed was so far behind the curve it needed to shift to a restrictive policy more quickly. Second, three hikes leaves open the possibility of using one quarter to initiate quantitative tightening (this would follow the 2017 playbook), so they already have four policy moves in mind for 2022. That leaves open the possibility of a March rate hike yet still holding the 2022 dots at three.

For the Fed to get more hawkish early in the year, we should be looking for signs that the inflation forecast is already in jeopardy. Remember, there is a widely held expectation that the Fed will get helped by the base effects pulling inflation lower after the first quarter. I would be cautious here as the Fed should look through the base effects to the monthly numbers; the Fed should clarify this distinction. The Fed could be waiting for that inflation decline before becoming more hawkish. So, my advice is to watch the month-over-month inflation numbers. The second thing to be watching is wages. The Fed is betting that wage pressures don’t intensify (note that Powell talked about wages as a signal of tightness in the labor market). That’s an obvious implication of the sustained 3.5% unemployment forecast starting next year in the context of declining inflation throughout the forecast horizon. If wage pressures become more obvious or it looks like unemployment will be sinking below 3.5% by the end of the year, the Fed will turn more hawkish. Third, of course, is watching measures of long-term inflation expectations.

That’s all for today. A lot to process after a busy week.

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