Williams, Waller Help Clear the Way for 50
Fed officials continue to foam the runway for a series of 50bp hikes with the only real question in the near-term of whether it is a series of two or three (or more!) hikes. Over the medium-term, the question is whether the Fed needs to move to modestly versus aggressively restrictive policy. There is wide agreement among Fed officials that they can pull off a soft-landing, but what else do you expect them to say?
We already knew from the minutes that 50bp was on the table at the March meeting, and the only reason it didn’t rise further to the top of the options was Russia’s invasion of Ukraine. Since then, most Fed speakers have fallen in line with language that does not admit to a 50bp hike in May as a foregone conclusion while still making it clear that we should consider it a foregone conclusion. Last week, for example, Federal Reserve Governor Christopher Waller reiterated his preference for 50bp, via CNBC:
“I think the data has come in exactly to support that step of policy action if the committee chooses to do so, and gives us the basis for doing it,” he said during a live “Closing Bell” interview with CNBC’s Sara Eisen. “I prefer a front-loading approach, so a 50-basis-point hike in May would be consistent with that, and possibly more in June and July.”
Similarly, New York Federal Reserve President John Williams told Bloomberg:
“I think that’s a reasonable option for us because the federal funds rate is very low,” Federal Reserve Bank of New York President John Williams said Thursday in a Bloomberg Television interview. “We do need to move policy back to more neutral levels.”
The “front-loading approach” and the “need to move policy back to neutral” argue for more than one 50bp hike, and we think the Fed will follow up a 50bp hike in May with another at the June meeting. That’s the only way to push rates to the neutral range of 2-2.5% in a timely manner. Plus, as Waller explains, this is the time to move:
“I think we’re going to deal with inflation. We’ve laid out our plans,” he said. “We’re in a position where the economy’s strong, so this is a good time to do aggressive actions because the economy can take it.”
Fed hawks will push aggressively for 50bp rate hikes in May and June if only to avoid the problem of any crosscurrents in the data, as well as softer inflation readings on the back of falling used vehicle prices, pushing the consensus back to 25bp moves. While current odds favor 50bp in July as well, that outcome remains still up in the air. Watch for any cracks that emerge in the economy, especially housing, to give hints on which path the Fed will take; the doves will take such cracks as evidence the Fed needs to shift back to smaller hikes.
Overall, the Fed hawks are winning the battle to bring rates up to neutral by the end of the year. The path thereafter is the next critical policy decision. The Fed has already signaled it expects to take policy slightly above neutral in 2023, but there remains a wariness to argue for a more aggressively restrictive policy. St. Louis Federal Reserve President James Bullard has been at the forefront of arguing for rates above neutral by the end of the year. Via last week’s Financial Times interview:
“Neutral is not putting downward pressure on inflation. It’s just ceasing to put upward pressure on inflation.” “We have to put downward pressure on the component of inflation that we think is persistent,” he added. “Getting to neutral isn’t going to be enough it doesn’t look like, because while some of the inflation may moderate naturally . . . there will be a component of it which won’t.”
Bullard believes the Fed should raise rates by another 300bp this year, but admits this goal is “aspirational.” While Bullard has been an excellent leading indicator of where the Fed has moved this cycle, the consensus has cleared lagged behind him. Waller though sounds like he is leaning in Bullard’s direction:
“I think we want to get above neutral certainly by the latter half of the year, and we need to get closer to neutral as soon as possible,” Waller said.
It’s not just about going substantially past neutral, but when to signal such a move. My primary takeaway from the Brainard speech last week (see Tim Duy’s Fed Watch 4/12/22) was that even if the Fed needs to go well beyond neutral, there is a limit to how much above neutral the Fed wants us to price in right now. The Fed does not want a disruptive movement in rates to create a sudden slowing in activity that elevates recession odds. The rise in mortgage rates last week to a five-handle highlights such concerns. Such an outcome might be counterproductive in that too much near term slowing could put a halt to rate hikes. Better instead to find the right mix of policy signaling that “boils the frog” on the U.S. economy rather than shocking the economy into lower inflation. Note that Bullard stands apart on this topic and references the 1994-95 cycle as an example of a soft landing. In that cycle, the Fed raised rates aggressively but was swift to cut. He thinks it is a “fantasy” to believe only rates modestly above neutral will bring inflation back to target.
Still, the current consensus hopes that cooling inflation requires an only modestly above neutral policy. Williams for example says that the Fed only needs to go a “little bit above neutral,” the story told in the latest Summary of Economic Projections (SEP). The Fed still fundamentally retains hope that most of the inflation of the past year will dissipate on its own while inflation expectations remain well-anchored. In such a scenario, the Fed does not need a recession to meet its inflation target within the forecast horizon. Williams again, via the Wall Street Journal:
In an economy with strong momentum, “we have a very unique situation with the demand for labor, obviously, much stronger than the supply,” Mr. Williams said. Fed policy will aim to reduce excessive demand, he said, which means “I don’t think we have to decrease employment or raise unemployment so much—it’s just take the froth, if you will, out of the economy and get in on a more sustainable basis.”
This follows along with Brainard’s story from this week, as well as Federal Reserve Chair Jerome Powell’s. The idea is that the Fed can take the pressure off the economy and reduce job openings in such a way that the labor market is no longer overheating but hiring holds up such that unemployment remains roughly steady. The gap between openings and the number of unemployed provides a rough estimate of how much of a reduction in job openings that plan requires:
I think we need to get openings down by roughly 3 to 3.5 million to hope to recreate 2018-19 conditions. I will leave it to the reader to decide if that can be accomplished without recession, but I don’t think so. It’s a sharp drop from current levels:
Once we tip the balance on the economy, it typically becomes something of a one-way trip. And I don’t think the balance tips with rates at or modestly above neutral. Still, note that this does not mean a recession is imminent. That call is still a way in the future.
At this juncture, I remind readers that neutral is a moving target. If the neutral real rate has risen, or underlying inflation pressures are more persistent, then the Fed’s current estimate of neutral is too low. Richmond Federal Reserve President Tom Barkin spoke this week to the possibility of a regime shift in inflation dynamics:
There are a few reasons to think we may face more headwinds when it comes to containing inflation going forward. That is, we may need to navigate in the context of more medium-term inflationary pressure than we have experienced during the Great Moderation…
…If we find ourselves facing this “series of unfortunate events,” we will recognize headwinds that become persistent and adjust how we navigate. Our goal — 2 percent target inflation — wouldn’t change, nor would our longer-run ability to meet that goal, but the appropriate path to achieve it could.
Should the prevailing winds shift, we would be more likely to face periods with real forces imparting near-term inflationary pressure. These pressures could make “looking through” short-term shocks more difficult. As a consequence, our efforts to stabilize inflation expectations could require periods where we tighten monetary policy more than has been our recent pattern. You might think of this as leaning against the wind. Doing so would be consistent with our flexible average inflation targeting framework.
Barkin acknowledged that we don’t know if such a shift has occurred, and consequently advocates for assessing that possibility after first bringing policy to neutral. Be careful though with his claim that leaning against the wind is consistent with Flexible Average Inflation Targeting (FAIT). It is, but only up to a certain point. The Fed’s new framework does not specify a path when inflation is above target. The Fed isn’t going to target pushing inflation below 2% to meet a 2% average, which is why they aren’t looking to raise unemployment to get to a 2% average. Interest rates still hover far too close to the zero bound to risk attempting to meeting a 2% average from above. That means policy has an inherently inflationary bias, which is something we really don’t talk about. In any event, if the neutral rate has risen, then the Fed’s current signaling about getting to the neutral range of 2-2.5% or a touch above is a green light for ongoing overheating of the U.S. economy.
If the Fed continues to insist that it only intends to bring policy rates slightly above the current estimate of neutral, my hawkish concerns tell me that is the same as signaling it intends to let inflation fester underneath the surface of the economy. This is especially the case if rising underlying inflation has pushed the neutral rate higher. The Fed really doesn’t like the recession talk of recent weeks and came out in force to push back on the idea it is ready to trash the economy to get inflation back to target. That required the Fed to talk up the story that declining inflation will allow the Fed to soft land the economy. That talk may get even more traction if declining used vehicle prices continue to put downward pressure on core inflation.
As I wrote last week, I sense the Fed may embrace declining used vehicle prices as an “all clear” signal on inflation. Last year, the Fed basically said there was no inflation because it could be largely attributed to rising used vehicle prices, thereby letting inflationary pressures fester. It strikes me that the Fed may potentially make the same fundamental error as last year in that the Fed may use falling used vehicle prices to force the data into the Fed’s desired outcome (as for me, I have tracked supercore inflation and wage growth as key metrics on both sides of the used vehicle rollercoaster). The Fed really needs to get on record to clarify this issue (hint, hint, for the financial journalists out there). In any event, we should see some clarity on the inflation/overheating question by the third quarter.
In practical terms, when the Fed signals an intention to “do what it takes” to bring inflation under control, that to me is a message to flatten and invert the yield curve. If the signal is “we aren’t interesting in risking a recession because inflation will largely dissipate on its own,” I see that as a message to steepen the yield curve. Over the last week, we are getting the latter message. I am watching how that message evolves going forward.
Bottom Line: The Fed continues to press forward with its plan to get rates to neutral this year with front loading rate hikes. That sets us up for a series of 50bp moves, starting in May. The Fed has yet to commit to any steps beyond that point, with the consensus wary about pushing rate hike expectations too much above neutral until it has a clearer sense of the level of underlying inflation. Now we wait, tracking the inflation data and any wobbles in activity triggered by the rise in market interest rates that have already occurred. My expectation is that the Fed will eventually need to take rates above the current estimate of neutral, and there is a reasonable chance that the neutral rate has risen. That’s speculation, however, and if true the Fed and market participants will need to learn their way to that outcome.