A Hawkish Hike
The FOMC meeting today concluded with a “hawkish” hike. The Fed delivered the expected 25 basis points rate hike and signaled another six for this year. The risks, however, remain to the upside. Eight FOMC participants expect more than 175 basis points of rate hikes this year, implying a widespread belief that some of the upcoming moves will be 50bp hikes; we expect at least one of the next two meetings to conclude with a 50bp hike. Federal Reserve Chair Jerome Powell presided over a hawkish press conference in which he all but said the economy was overheating and the Fed had fallen behind the curve on inflation. If wage growth doesn’t soon slow or inflation fall back toward target more quickly, the dots will move up again at the June meeting.
The FOMC statement was largely as we anticipated. Not only did the Fed announce a rate hike, but it indicated it is the first of a series of hikes. The Fed also said it expects to begin reducing its balance sheet at a coming meeting. As we said ahead of this meeting, we think this will indicate a May announcement that QT will begin in June. Powell all but confirmed this in the presser, saying meeting participants made “excellent progress” in developing a plan and an announcement could come as soon as May. He didn’t just throw that out there without thinking it would in fact be May. Highlighting the Fed’s concerns about price stability, or lack thereof, the inflation line changed from:
Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.
Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.
The key change is the addition of “broader price pressures.” That indicates the Fed now acknowledges what we have long believed: we are well past the transitory story. Inflation has become entrenched.
FOMC participants substantially revised up their rate hike expectations. We were looking for 10 rate hikes between now and the end of 2023 split either five/five or six/four in each of the next two years. The Fed delivered a little more than ten hikes and front-loaded seven into this year. That front loading was more than we expected. Not only was this a giant move from the three rate hikes for 2022 in the December SEP, but it reinforces that the guidance we were getting from some Fed presidents ahead of this meeting – “three, maybe four, hikes” – was completely nonsensical. That said, the key point is what we have long warned about: the Fed will eventually need to signal above neutral rates as the only way to guide inflation back down to target. The Fed did this a little earlier than we thought, but that simply reveals the heightened inflation concerns. We think that if the Fed really expects to get inflation under control, rates will need to end 2022 closer to the highest dot, 3.125%, than the current median dot. We suspect this was St. Louis Federal Reserve President James Bullard’s dot. He dissented at this meeting, seeking 50bp. We didn’t think there would be a dissent given that the door is clearly open for a 50bp rate hike at the next meeting, but if you want to get 300bp of rate hikes in this year, frontloaded, almost every meeting must be 50bp.
The upward revisions to the inflation projections were above expectations, another attempt by the Fed to finally get ahead of the inflation forecast. The 2022 core-PCE inflation forecast was 4.1%, falling to 2.6% and 2.3% in the subsequent two years. Such a sharp revision forced the rate forecast above neutral, although even then the Fed’s forecast remains primarily based on hopes that inflation still proves to be a primarily a transitory problem that largely unwinds on its own. The forecast shows just a small increase in the unemployment rate from an expected 3.5% at the end of this year to 3.6% at the end of 2024. That’s not sufficient to drive any meaningful deceleration of inflation when the Phillips Curve is still assumed to be flat. Fundamentally, I think the Fed knows it needs to do more than this latest SEP suggests and is still dragging out the process of shifting rate expectations higher. Powell will be ratcheting up our expectations again at the next meeting.
The Fed’s GDP forecast for this year appears to us to be overly pessimistic. We expected some downward revision based on the Ukraine shock, but the 2022 adjustment from 4% to 2.8% is substantial. This may have been a consequence of real time GDP trackers like the Atlanta Fed GDP Now measure. Inventory adjustment and imports have weighed down the headline number in the Atlanta version, but the underlying estimate of real final domestic sales is close to 5%, which is solid demand. We think there is room for upside revision here.
The Fed estimate of the long-term neutral rate may still be holding a lid on the long end of the yield curve. The Fed’s estimate of the long-term rate edged down to 2.4% from 2.5%, largely but not entirely because there are two fewer participants. I don’t think this is a material change. A more fundamental issue is that the Fed is signaling it expects to tighten policy to an, at least, modestly contractionary level. Long rates can’t really embrace that though because market participants believe the Fed will be cutting rates again soon thereafter. And the higher the Fed lifts the terminal rate relative to the neutral rate, the steeper those expected rate hikes will be. If the Fed’s estimate of the neutral rate is a lid on rates, we would expect the yield curve to flatten further and even invert with the next iteration of more hawkish rate projections. If the Fed wants to get the long end of the curve up, I think it should stop telling the market the long end should be at 2.4%. Time will tell if market participants can push longer rates substantially higher under the current guidance.
Powell’s press conference confirmed what we believed was his deepening hawkishness. Two points were especially important. First, Powell described the current conditions in the labor market as “unhealthy”:
Well, if you take a look — take a look at today’s labor market what you have is 1.7 plus job openings for every unemployed person. So that’s — that’s a very, very tight labor market. Tight to — to an unhealthy level, I would say. So in principle, if you were — if — or let’s say that our tools work about as you described and the idea is we’re trying to better align demand and supply, let’s just say in the labor market, so it would actually if you were just moving down the number of job openings so that they were more like one to one, you would have less upward pressure on wages.
That’s a huge admission that the labor market is overheating. Powell implies the solution to the overheating is to slow demand sufficiently to bring job openings down more in line with labor supply. In this manner, the Fed can reduce the pressure on the economy without creating higher unemployment. It’s a good idea, but historically we don’t see large drops in job openings without a recession. The second key point is that the Fed needs to “restore” price stability:
So, you know, as I mentioned the committee acutely feels its obligation to — to move to make sure that we restore price stability and is determined to use its tools to do so.
Powell mentioned “restoring” price stability repeatedly during the press conference. If the Fed needs to “restore” price stability, that means is has “lost” price stability, or in other words it is behind the curve on inflation. This acute awareness that the Fed now faces an overheating labor market and has already lost price stability will leave the Fed with a hawkish bias when evaluating incoming data. Indeed, Powell made this clear:
We’re not going to let high inflation become entrenched. The costs of that would be too high. And we’re not going to wait so long that we have to do that. No one wants — no one wants to have to really put restrictive monetary policy on, in order to get inflation back down. So, frankly, the need is one of getting back up, getting rates back up to more neutral levels as quickly as we practicably can, and then moving beyond that if that turns out to be appropriate.
I think when Powell talks about “really restrictive” policy, he means restrictive enough to trigger a recession, not what he thinks is currently in the SEP. Powell said the probability of recession is not particularly elevated this year, but “this year” is doing a lot of work in this observation. Yes, as we repeatedly argue, and Powell agrees, demand now is very strong. But that is what’s going to keep the Fed tightening, and if history is any guide, I don’t see that inflation elevated as it is does not come down absent a recession.
Bottom Line: The Fed is catching up to our inflation view, but it can still move farther on the policy reaction and is poised to do so. We think the data will drive the Fed to hike rates 50bp at one of the next two meetings – and even possibly both if the inflationary trends worsen – and that it is more likely than not that this year the Fed implements at least 200bp of rate hikes, relative to our previous baseline of 175bp with a risk of more. The Fed has all but validated that upside risk. We need the inflation data to turn around soon to push that baseline back down.