Tim Duy’s Fed Watch, 12/20/21

Published on December 20, 2021
SGH Insight
It is increasingly recognized that Covid isn’t going away and consequently the focus needs to shift from cases to outcomes. President Biden ran on a campaign of bringing back “normality” and that isn’t going to happen with a nonstop media focus on the number of cases regardless of the degree of severity. The narrative must change, and I suspect will be changing in such a way that further lessens the negative domestic economic impact of the repeated waves of Covid. From what we are seeing now, the lack of vaccine durability, the potential for vaccine-evading variants, both of which mean ongoing breakthrough infections and create the need for a never-ending vaccination campaign, and the unwillingness of a percentage of the population to be vaccinated, suggests the administration will always appear to be fumbling the ball until it develops a strategy that acknowledges those factors and Covid as an endemic disease.
Market Validation
Policy Validation

Politico 12/21/21

ANOTHER COVID SPEECH — At 2:30 p.m., President JOE BIDEN will once again address the nation and outline another new plan to tackle another new, more highly transmissible variant of the coronavirus that threatens to once again push America’s health care system to its breaking point. The emphasis of the latest Biden plan, according to the White House, is to “mitigate the impact unvaccinated individuals have on our health care system, while increasing access to free testing and getting more shots in arms to keep people safe and our schools and economy open.”

It’s a plan that recognizes a few hard-earned truths about the two-year-old pandemic in America: Vaccine holdouts are here to stay, and with every new Covid-19 wave they will overload hospitals, which will need extra government support. For everyone else, widespread testing and boosters are the only alternative to lockdowns and recession.

Monday Morning Notes, 12/20/21

If You Don’t Have Time This Morning

The Fed is positioned to hike rates as early as March with Omicron as the only real stumbling block to that plan. More interesting this week could be a shift in the White House Covid messaging from a focus on case counts to severe outcomes. This new narrative could help further lessen the policy response and economic impacts of this and future Covid waves.

Recent Data and Events

Retail sales for November came in softer than expectations after a blowout October report. Given the normal variability of the report, I would be wary of claiming there is any change in the underlying trends:

Note that the Chicago Fed retail sales tracker has been a good indicator of the direction of the miss relative to consensus.

The housing market remains hot, with building starts climbing once again:

Single family remains on the pre-pandemic trend:

Homebuilder confidence remains high, but the sector continues to struggle with supply constraints. Demand for owner-occupied housing drives builder optimism as high prices have yet to undermine the demographic trends driving momentum in the housing sector. Note also that rising rents make home buying more affordable in relative terms while strong income growth also supports the sector.

Industrial production rose in November:

Auto production, however, remains constrained by supply chain problems.

Every month that auto production remains below pre-pandemic levels is another month of growing pent-up demand that will support car prices even after production normalizes.

Producer price inflation remains elevated:

There is no direct line between producer and consumer prices, but the persistent high rate of producer price inflation speaks to the ongoing underlying pressure on firms to push costs onto customers.

The winter Covid wave is gathering steam quickly as Omicron pushes more European nations to enact hard lockdowns during the holidays. Per usual, we should expect some weakness in the leisure and hospitality sector this winter, and the degree of this weakness, along with the potential inflationary pressures, will help guide the Fed’s next move. Hard lockdowns in the US are not politically possible anymore as they will meet stern resistance from both the vaccinated and the unvaccinated. Note that a high level of infections would lead to localized firm shutdowns due to lack of staffing and this will likely weigh on headline jobs numbers. Another story to watch is that the Biden Administration is moving toward changing the messaging on Covid. Via CNN:

Yet Biden and his team have all but ruled out new lockdowns, and behind the scenes, administration officials have been debating how to shift public attention from the total number of cases — which appear likely to surge, even if many are mild — toward the number of severe infections that are overloading health systems and causing interruptions to normal life.

Some of Biden’s advisers are encouraging the administration to begin discussing publicly how to live alongside a virus that shows no signs of disappearing, a potentially stark shift in messaging for a White House that once touted “freedom from the virus.”

Steering public attention away from the total number of infections and toward serious cases only — as some Biden advisers have encouraged — could prove a challenge after nearly two years of intense focus on the pandemic’s every up and down. It is a part of a growing conundrum that Biden faces as the Covid-19 pandemic refuses to abate.

It is increasingly recognized that Covid isn’t going away and consequently the focus needs to shift from cases to outcomes. President Biden ran on a campaign of bringing back “normality” and that isn’t going to happen with a nonstop media focus on the number of cases regardless of the degree of severity. The narrative must change, and I suspect will be changing in such a way that further lessens the negative domestic economic impact of the repeated waves of Covid. From what we are seeing now, the lack of vaccine durability, the potential for vaccine-evading variants, both of which mean ongoing breakthrough infections and create the need for a never-ending vaccination campaign, and the unwillingness of a percentage of the population to be vaccinated, suggests the administration will always appear to be fumbling the ball until it develops a strategy that acknowledges those factors and Covid as an endemic disease.

In other Covid news, note that the U.S. may be in a relatively better space for this latest wave because only the Pfizer and Moderna vaccines, when boosted, appear able to stop Omicron infections. And in an interesting development, researchers at the Oregon Health & Sciences University found that breakthrough infections provide “super-immunity” protection.

Finally, Senator Joe Manchin put the Democrats’ economic and social agenda on ice by saying he will not vote for the Build Back Better act. Democrats will need to try to move forward a more limited agenda if they hope to pass anything next year.

Upcoming Data and Events

Fairly busy data week but most of the numbers will come at the end of the week when everyone will be packing up for the holidays. Existing and new home sales reports this week are expected to confirm a robust housing market in November. Likewise, Wall Street anticipates the manufacturing report will show continued strength in capital goods orders as firms expand to meet elevated levels of demand. We get consumer confidence reports from the Conference Board and the University of Michigan. The focus of the week will be on Thursday’s personal income and outlays report. The numbers to watch are obviously headline and core inflation although at this point how inflation evolves probably has more of an impact on Fed policy late next year rather than immediately. The already high inflation and low unemployment has the Fed itching to pull back on accommodation; Omicron is the factor that would most likely derail the Fed’s plans at this point. No Fed speakers on the schedule this week so far.

Day Release Wall Street Previous
Wednesday Existing Home Sales, Nov. 6.55m 6.34m
Wednesday Conference Board Confidence, Dec. 110.3 109.5
Thursday Capital Goods Nondefex Air, Nov. P, MoM 0.5% 0.7%
Thursday Initial Jobless Claims 200k 206k
Thursday Personal Income, Nov., MoM 0.5% 0.5%
Thursday Personal Spending, Nov, MoM 0.5% 1.3%
Thursday PCE Prices, Nov, MoM 0.6% 0.4%
Thursday Core PCE Prices, Nov, MoM 0.4% 0.3%
Thursday New Home Sales, Nov. 770k 745k
Thursday Univ. Of Mich. Sentiment, Dec. F 70.4 70.4
Thursday Univ. Of Mich. 5-10Y Inflation Exp., Dec. F 3.0%

Fed Speak and Discussion

The year is winding down, and Fed speak drying up this week. At this point we are just setting the stage for 2022. Federal Reserve Governor Christopher Waller provided some helpful comments last Friday that confirmed the narrative I have been selling. The data flow since the November meeting gave Fed hawks the upper hand as they pulled the consensus toward a substantially more aggressive removal of accommodation. And despite a tendency it still seems in markets and by analysts to dismiss such comments on a hawk-dove spectrum balance, in effect there are no “doves” left, with inflation a problem, now. The entire FOMC has been pivoting, and has moved dramatically, including, and now led by Chairman Jerome Powell. More on that below. The evolution of policy in 2022 will depend on the degree to which the data supports that policy pivot.

Waller on the labor market:

In light of November’s job report, I believe the economy is closing in on maximum employment. Though job creation was lower than expected last month, the number indicated another solid increase in jobs. Accounting for retirees leaving the workforce, I estimate that employment is only about 1-1/2 million jobs below its February 2020 level, when monetary policy was less accommodative and unemployment was at a 50-year low and below Federal Open Market Committee (FOMC) participants’ estimates of the longer-run unemployment rate. The unemployment rate dropped to 4.2 percent in November, just a touch above the median of FOMC participants’ longer-run level of 4 percent. The economy seems to be on track to grow at an annual rate of 6 to 7 percent this quarter and by nearly that much in the first quarter of 2022.

I see three key points to watch in Waller’s description of the labor market and the economy. First is that after accounting for retirees, jobs are just 1.5 million shy of the pre-pandemic level. This is another example of the Fed’s new, less optimistic view of the supply side of the labor market. The Fed just doesn’t see the jobs shortfall as it did in November, and that means the unemployment rate is back to being a “real” number. The second key point is that he draws attention to the longer-run projection of 4% unemployment, meaning we are sitting just a hair above full employment. The third key point is the forecast of 6-7% growth in the final quarter of 2021 and first quarter of 2022. That rate is clearly high enough to drive unemployment down further, and quite quickly. That’s basically saying the odds of reaching the Fed’s full employment goal are very, very high.

Waller on inflation:

Turning to inflation, it is alarmingly high, persistent, and has broadened to affect more categories of goods and services, compared with earlier this year. Wages are rising, and business contacts are reporting in the Fed’s Beige Book that they are comfortable passing on increases in input costs to their customers. I have argued for some time that there are upside risks to inflation, and with inflation exceeding the FOMC’s 2 percent target for some time now, I strongly supported the Committee’s decision this week to speed up the pace of the tapering of asset purchases. This action gives us increased flexibility to adjust monetary policy as needed in 2022.

That’s pretty straightforward; he isn’t mincing words. Waller has long been more concerned about inflation than many of his colleagues, and more hesitant to embrace the strategy of looking through every print to find reasons to justify the “transitory” story. The Fed overall has moved in his direction.

Waller on policy:

Assuming this new pace of reductions in our monthly asset purchases continues, the FOMC will end purchases in March. The appropriate timing for the first increase in the policy rate, of course, will depend on the evolution of economic activity, something that I will be closely monitoring. But given my expectations for inflation and labor market conditions, I believe an increase in the target range for the federal funds rate will be warranted shortly after our asset purchases end.

There remains, it seems, a pocket on Wall Street that just doesn’t want to see the Fed’s pivot. Indeed, I saw commentary immediately after Waller’s remarks that “shortly after” meant explicitly no rate hike in March. Waller though is nice enough to just get it out in the open in the Q&A. Via Bloomberg:

“The whole point of accelerating the tapering was to end it much faster in March so the March meeting could be a live meeting. That was the intent,” Waller said Friday in response to a question after a speech to the Forecasters Club of New York. “It’s going to depend on what the data comes in, but March is a live meeting for the first rate hike.” The Federal Open Market Committee meets March 15-16.

We don’t have to guess if March is a live meeting. It just simply is a live meeting. What would stop a March hike? Omicron:

“My outlook is that it’s a very likely outcome that it could happen in March,” Waller said. “It would take something like severe disruption from omicron to delay labor market improvement or keep unemployment from falling, to keep March from being a key date to think of for liftoff.”

As I wrote in my note last week, right now the liftoff debate is March or May and if we didn’t have Omicron breathing down our necks, it wouldn’t be much of a debate at all. Omicron is going to mess with the numbers; it’s just a matter of how much and whether the Fed wants to look through it regardless of the numbers.

Waller provided us some of his thinking on balance sheet policy:

Waller said he wanted to go “sooner and faster” than last time — when the Fed waited three years between ending the purchase program before starting to let the balance sheet shrink — and argued this might mean fewer rate hikes.

“If we start doing some balance sheet runoff by summer, that’ll take some pressure off, you don’t have to raise rates quite as much,” he said. “My view is we should start doing that by summer.”

Notice that Waller is thinking that balance sheet runoff (quantitative tightening, or QT), can substitute for rate hikes. This is a space the Fed is thinking about, and in that space, I think they will be considering the shape of the yield curve. To me, this is an early indication of where policy could go – more QT – if rate hikes threaten to invert the yield curve yet the economy still needs tighter policy. This is very early in the process, and I know I have talked with some of you about this being a mess in that the Fed is managing policy with a price and a quantity at the same time, but it needs to be on our radar. Also, the tradeoff he talks about between rate hikes and QT is consistent with my conjecture last week that the reason some Fed officials don’t have four hikes in the 2022 forecast is they are reserving one quarter for starting QT. This, of course, could change if conditions warrant.

This from Waller is also helpful:

He also favored getting the size of the balance sheet back to around 20% of gross domestic product versus 35% today, with a focus on increasing the share of Treasuries versus mortgage-backed securities.

“I would like any runoff of MBS to be reinvested, if we’re doing reinvestment, back into short-term Treasuries,” he said.

That gives us some guidance on the potential end point and composition of QE. Waller’s suggestion on MBS should be considered seriously if only for the optics. MBS purchases might influence overall financial conditions and not the housing market directly but it’s still not a great look when shelter costs are running hot and feeding into inflation numbers.

Finally, I saw some commentary to the effect that we should discount Waller as a hawk outside the consensus like his former boss St. Louis Federal Reserve President James Bullard. I wouldn’t do that. First, the hawks have been on the right side of the debate all year. And arguably, there aren’t any doves left, the data crushed that side of the policy argument. Second, as a Board member, Waller is not going to put a substantial amount of daylight between himself and Chair Powell. Nothing Waller said is inconsistent with the takeaways from last week’s FOMC meeting and Powell’s presser. And third, Waller has been a straight shooter who provides very helpful and detailed speeches that do not always hew to the conventional wisdom. I wouldn’t discount his comments out of hand.

Bottom Line

We know where the Fed is positioned. For the moment, we are just waiting to ride out the Omicron wave to see what the situation is on the other side.

Good luck and stay safe this week!

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