Final Thoughts Heading into the FOMC Decision
Some things I am thinking about as we wait for the outcome of the FOMC meeting:
It’s the politics? In retrospect, it is going to be hard to ignore that the Fed’s abandonment of very hard forward guidance in favor of a fresh hawkish pivot happened to occur between the Biden/Powell/Yellen meeting and next week’s Humphrey-Hawkins testimony. Coincidence? Maybe. Still, Federal Reserve Chair Jerome Powell revealed his sensitivity to the brewing political firestorm over inflation when he made a direct statement to the public at the May FOMC press conference. Moreover, he is always quick to note that price stability is part of the Fed’s Congressional mandate. It’s realistic to think that Powell needed to have some forceful policy action in hand to show Congress next week. While all of us may understand the Fed’s claim that the two-year Treasury rate is the best indication of the stance of monetary policy, that’s a harder story to sell to the public and Congress. What they see is $6 a gallon gas and the Fed’s policy rate sitting at 0.875%. The optics just aren’t good. Still, while ultimately the Fed answers to Congress, Powell isn’t doing anything he doesn’t think necessary. Inflation is just too persistently high to ignore.
Has forward guidance failed? As noted above, the Fed’s application of forward guidance isn’t what we might call user friendly from the public’s point of view. It has created a large gap between the policy rate and the actual level of financial tightening. In theory, that’s an optics problem more than an economic one. But correcting the optics problem resulted in a now roughly 60bp move in two-year rates over the span of just three trading sessions. This is exactly the kind of “Taper Tantrum” event the Fed’s emphasis on forward guidance and slow walking tapering was meant to avoid. Forward guidance as applied by the Fed may work when inflation is close to target, but not so much now.
Is the Fed hard stopping the economy? When we start talking 75bp moves, the odds of recession start rising. The Fed will almost most definitely hard stop the housing market. Even if you believe, as I do, the underlying fundamentals are strong, shocking mortgage rates up to the 6.25% range will, and already is, having an impact. Buyers will just sit it out and wait for mortgage rates to fall, which is starting to happen. Redfin and Compass announced layoffs today, and other real estate firms are sure to follow. Downstream sectors, like consumer durables, will feel the hit later. The crypto collapse will yield similar outcomes; Coinbase announced today it was cutting 18% of its staff. Yes, the economy has a lot of momentum, but we are heading for some kind of rough patch.
Is 75bp the new norm? Prior guidance said the Fed would continue with 50bp hikes until inflation rolled over, so will Powell signal that the same is true of 75bp? I can’t see that. It might not be until the end of the year before we see a string of sufficiently low inflation numbers such that the Fed sees the path to price stability. The Fed’s not going to commit to a path likely to mean 75bp hikes at each meeting for the rest of the year, but Powell will not rule out another 75bp hike in July or later. Powell will frame this in terms of a more “expeditious” move toward neutral and I think will not repeat the error of providing strong guidance like that leading up to this meeting.
Aspirational market pricing? I see market participants pricing in a peak Fed funds rate at 4% next spring, an overly hawkish view that might not be validated by the SEP. I am not far behind that as I see median dots of 3.375% and 3.875% for 2022 and 2023, respectively. As I wrote that puts a 4+% rate potentially in play and that will likely be revealed in some dots, but I don’t think the median will make it there. And to be sure, whatever the end result, this is a Volcker-moment for Powell. The Fed will have escalated from moving in 25bp increments to 75bp over the course of just three meetings, a remarkably hawkish move as the Fed desperately tries to catch up to the inflation situation. Still, as I wrote Monday, this is a dramatic shift and getting consensus will be like herding cats and while I am certain Powell can get a 75bp rate hike, the SEP guidance might still fall short of what I think would be a forecast that provides a credible path to 2% inflation. In short, when I see a 60bp move in rates I wonder that even a hawkish Fed won’t be hawkish enough to sustain that move.
That’s all, no bottom line. Good luck tomorrow, it will be a challenge to process this new policy pivot.