On The Dots
You ask, I answer, now with some quick thoughts on next week’s dot plot.
The theme for the week is my expectation of a high probability that the Fed hikes rates in March. My view is that the balance of risks is changing rapidly, as evidenced by the Fed’s sharp pivot from patience to accelerating the pace of tapering, that March must be considered in play. To be sure, we have three months of data before we get there, so anything can happen, but the data and the Fed narrative shift are driving us in that direction.
That said, I don’t think a high probability of a March rate hike in 2022 will be validated by next week’s dot plot. Where the Fed is now and where the Fed will be in three months are two different things. As of September, FOMC participants were split on the question of a 2022 rate hike. I anticipate the December SEP will reveal a median of two rate hikes in 2022. A natural interpretation of this would be rate hikes in June and December. Accelerating the taper only increases the optionally to hike before June, it doesn’t guarantee such a hike.
Similarly, would a rate hike in March be consistent with my forecast of three rate hikes in 2022? Well, here again, I don’t want to pull clients too far away from where the Fed is now versus where the Fed might find itself in three months. If I don’t anticipate the Fed will validate a March rate hike, it certainly won’t validate four hikes in 2022. Moreover, even if four rate hikes feels right with a start date in March, I still need to account for the risk that inflation eases in the back half of the year and the Fed uses that as a reason to pause. The Fed could start in March with a signal of four hikes and then change course again. We probably should expect the Fed will be nimble in this cycle, much as the Fed started the last cycle in December of 2015 and then almost immediately shut it down until a year later.
The expected path of rate hikes through 2024 will likely be pulled higher along with the 2022 dots. I think the 2024 dots will show policy rates just below or at the Fed’s estimate of neutral, 2.5% (this will support the narrative that monetary policy remains accommodative even after rate hikes commence). Of course, as of now the market has priced in a terminal rate in the 1.5 to 2% range and the 10-year treasury yield is just 1.48%. The implication is that the Fed is overly optimistic about the path of rates and the Fed doesn’t have much room to tighten without inverting the yield curve. Or is current market pricing just wrong? I don’t have an answer for that question yet. I don’t think we have enough information to say the terminal rate is higher or lower than the last cycle. I think we won’t know until the Fed starts raising rates. If the economy and markets can handle rate hikes, I would anticipate the expected terminal rate rises and the yield curve shifts up. This is my current expectation, but I don’t sense much conviction now that the economy can sustain substantially higher rates.
On a final note today, what I am mostly watching for next week is a change in the narrative. The change in the narrative is what supports the Fed’s policy pivot and increases the risk that the Fed needs to hike at the end of next quarter. There will be multiple elements to the new narrative, but I think the key shift will be essentially from “supporting the labor market requires patient policy” to “supporting the labor market requires maintaining price stability.” Along with that shift, the balance of risks is now on the side of inflationary outcomes and as such the Fed needs to adjust policy accordingly. This means that Fed officials are primed to respond to higher-than-expected inflation pressures in the same way that triggered the Fed’s abrupt hawkish pivot. This is what creates the risk of a March rate hike assuming the data holds on the current trends of strong demand growth, rapidly falling unemployment, and unacceptably high inflation. Time will tell if the data continues in that direction.