Tim Duy’s Fed Watch, 6/13/22 (2)

Published on June 13, 2022
SGH Insight
Powell’s Volcker Moment

That was another unpleasant day on Wall Street with stocks, bonds, and crypto all trading deep in the red. The proximate cause was a repricing of risk ahead of the FOMC meeting on the concern that the Fed would deliver a hawkish message with the dots and possibly surprise with a 75bp rate hike. One of the wild cards for me heading into this meeting was the Fed’s reaction function with respect to the elevated inflation and inflation expectations numbers. I think the Fed will reveal that reaction function by opting for the 75bp move.
Market Validation
Bloomberg

The Federal Reserve raised interest rates by
75 basis points -- the biggest increase since 1994 -- and Chair
Jerome Powell said officials could move by that much again next
month or make a smaller half-point increase to get inflation
under control.


Powell’s Volcker Moment

That was another unpleasant day on Wall Street with stocks, bonds, and crypto all trading deep in the red. The proximate cause was a repricing of risk ahead of the FOMC meeting on the concern that the Fed would deliver a hawkish message with the dots and possibly surprise with a 75bp rate hike. One of the wild cards for me heading into this meeting was the Fed’s reaction function with respect to the elevated inflation and inflation expectations numbers. I think the Fed will reveal that reaction function by opting for the 75bp move.

If I take Fed speakers at face value, the expectations numbers should be very important. The Wall Street Journal reitered the importance of expectations today:

A string of troubling inflation reports in recent days is likely to lead Federal Reserve officials to consider surprising markets with a larger-than-expected 0.75-percentage-point interest rate increase at their meeting this week.

Before officials began their pre-meeting quiet period on June 4, they had signaled they were prepared to raise interest rates by a half percentage point this week and again at their meeting in July. But they also had said their outlook depended on the economy evolving as they expected. Last week’s inflation report from the Labor Department showed a bigger jump in prices in May than officials had anticipated.

Two consumer surveys have also shown households’ expectations of future inflation have increased in recent days. That data could alarm Fed officials because they believe such expectations can be self-fulfilling.

As we wrote this morning, 75bp is going to be on the table at this meeting, and there was a clear risk the Fed chooses that option. Going into this meeting I believed the Fed was signaling a hawkish outcome even given my expectation of a flat reading on Michigan expectations. If the Fed is in fact data dependent as it claims, and sensitive to inflation expectations as it claims, then this new information should push the Fed to be more hawkish than my initial expectation.Indeed, this should have outsized importance given the critical role of inflation expectations in the Fed’s policy framework. Also, the phrasing in this Wall Street Journal piece says Fed officials were surprised by the May report, whereas I believed they anticipated the number. Ultimately, the totality of the inflation situation is too dire for the Fed to hold onto previous guidance.

I interpret the escalation of the 75bp warning in the latest Wall Street Journal article as a signal that the Fed is leaning in favor of the bigger move. I think it mostly likely that solid sourcing triggered the change in tone. I very much don’t relish the idea of flip-flopping on calls in the final hours leading up to a meeting. You can reserve bragging rights that you got the call right, I suppose, but for me that’s cold comfort.

The problem for the Fed is that inflation expectations, like inflation last year, has become a “boiling the frog” problem. The Fed finds a way to dismiss any one number by bundling it into the Index of Common Inflation Expectations and assuming that the resulting metric is the correct measure of expectations. Eventually though you look back and realize that the Michigan number is up over 100bp since the pandemic began and that, wow, maybe the trend was important.

Similarly, while the New York Fed three-year inflation expectations number held steady at 3.9% in June (the one-year number rose), and has more or less been moving sideways since August, it is up roughly 150bp since the pandemic began which one would think would be notable but then New York Federal Reserve President John Williams tells us not to pay attention to this number his bank publishes regularly, pointing instead to the special surveys that of course show no rise of inflation expectations.

When you spend all your energy looking for reasons to deny that inflation expectations are creeping up, maybe one day you wake up and see what you missed. That’s what happened with inflation last year.

I suspect the Fed has concluded that the frog is now boiled. The Fed has said it will act forcefully if it thinks inflation expectations are unanchored, or about to become unanchored. Forcefully means stepping away from the reliance on forward guidance. This situation also reveals a weakness to the Fed’s reliance on forward guidance. The Fed has dramatically tightened financial conditions yet has raised rates only 75bp. The optics are not great when inflation is surging. Pushing rate hikes out into the future is not enough anymore to keep expectations in check.

With the two-year rate soaring over 50bp across the last two trading sessions, there is a real sense that the Fed has lost control of its narrative. Federal Reserve Chair Jerome Powell will attempt to use this meeting and the press conference to regain control of the narrative. I think he will try to do that withthe ultra-hawkish scenario I outlined this morning, which was 75bp plus a hawkish SEP that pencils in a credible forecast that brings inflation down in the context of the Fed’s framework. And, assuming the Fed wants to ensure that expectations are in control, we may be looking at 75bp again in July. I think the way this works out is that the SEP shows the equivalent of 50bp rate hikes for all of the rate hikes this year, for a total of 325bp of hikes, with the implication that 75bp hikes now pull some portion of those hikes forward. I think this puts a median Fed funds rate with a 4-handle in play for next year, or at least some of the participants will pencil that in.

Bottom Line: The Fed is heading toward the hawkish place I expected but will move there more quickly by opting for the 75bp rate hike this week. This is Powell’s Volcker moment.

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