Tim Duy’s Fed Watch, 2/9/22

Published on February 9, 2022
SGH Insight
Thoughts Ahead of CPI Number
The BLS releases the January CPI report tomorrow. Wall Street expects core-CPI inflation to be at 0.5%, consistent with the 0.45% prediction from the Cleveland Fed inflation tracking numbers. This will be an influential report given the Fed has us primed to watch the near-term inflation numbers to gauge the direction of policy. Some last-minute inflation thoughts heading into this meeting:
1. 50bp? Inflation at or above expectations will likely trigger market participants to increase probabilities of a 50bp rate hike in March. The Fed has set these dynamics in motion by not dismissing outright the idea of 50bp. If markets price in 50bp then the Fed will need to meet it or there will be an effective easing of monetary policy as market participants adjust to what will be perceived as a less-hawkish reaction function.
Market Validation
Bloomberg 2/10/22

Fed Hike Premium Ramps Up as Six Rate Hikes Priced for This Year

Fed-dated OIS swaps have quickly repriced across the front-end, showing six full 25bp rate hikes priced into the December FOMC in the aftermath of stronger-than-expected January CPI data.
While pricing in six 25bp rate hikes for the December meeting, swaps also briefly priced a 50bp rate hike for the March FOMC as a 50/50 chance -- 100bp, or four 25bp rate rises remain priced into the July meeting

Thoughts Ahead of CPI Number

The BLS releases the January CPI report tomorrow. Wall Street expects core-CPI inflation to be at 0.5%, consistent with the 0.45% prediction from the Cleveland Fed inflation tracking numbers. This will be an influential report given the Fed has us primed to watch the near-term inflation numbers to gauge the direction of policy. Some last-minute inflation thoughts heading into this meeting:

  1. 50bp? Inflation at or above expectations will likely trigger market participants to increase probabilities of a 50bp rate hike in March. The Fed has set these dynamics in motion by not dismissing outright the idea of 50bp. If markets price in 50bp then the Fed will need to meet it or there will be an effective easing of monetary policy as market participants adjust to what will be perceived as a less-hawkish reaction function.
  2. A downside miss? While unlikely, data can be noisy so we can’t entirely eliminate the possibility of a lower-than-expected number. Inflation below consensus will put downward pressure on expectations for a 50bp hike and would likely give a boost to risk assets.
  3. Watch the underlying trends. While there is a lot of attention on the details of the report, such as the path of used car prices, I worry that is a game of “whack-a-mole.” A decrease in used car prices would create additional spending power that could be absorbed later in higher prices of some other good or service. The possibility of such an upward shift in the underlying inflation trend is the fundamental issue the Fed needs to navigate. To track that issue, I focus on underlying trends such as “super-core” inflation:

4. Peak inflation? We may see more “peak inflation” talk this month and next, especially if we get a number above expectations. I can imagine a scenario where that evolves into a “risk on” narrative if market participants believe the decline will be sufficient to keep Fed tightening at a minimum in the second half of the year. Ironically, this too could ease financial market conditions.

5. We don’t know what inflation rate the Fed will ultimately tolerate. Atlanta Federal Reserve President Raphael Bostic today said he was hopeful that inflation will start to decline but expects 3% inflation by the end of the year, above the December SEP prediction of 2.7% core inflation. I don’t know if the consensus at the Fed will see 3% inflation as worth the risk of recession by pushing policy rates above neutral. The Fed could leverage forecasts of inflation returning to 2% as reason to hold back on further rate hikes at that point. The more Fed speakers talk about 3% inflation as if it were an acceptable outcome, the more market participants believe will that the Fed will not aggressively defend the 2% inflation target. I think the Fed needs to be careful around this point; the risk here is the Fed is normalizing higher inflation.

6. Companies are being rewarded by investors for raising prices. Amazon, Tyson, and Chipotle are recent examples of this phenomenon. Moreover, firms report customers are not pushing back against higher prices, which strikes me as anecdotal evidence that consumers have the nominal spending power and the willingness to absorb higher prices. I feel like there should be a window of opportunity here for firms to continue to raise prices ahead of any Fed-induced slowdown.

These are the things crossing my mind ahead of the inflation numbers.

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