Tim Duy’s Fed Watch, 7/27/22

Published on July 27, 2022
SGH Insight
I suspect that the Fed will be unhappy with the new market pricing and the implied easing of financial conditions, and we will see speakers push a hawkish story in coming days. Still, it may be hard to convince market participants that the Fed remains focused on inflation until the Fed hikes after the unemployment rate ticks higher. In other words, actions speak louder than words.
Market Validation
Bloomberg 7/29/22

Treasury Yields Bounce as Traders Reminded of Inflation Risks

A combination of data showing an ongoing acceleration in US inflationary pressures and commentary from a Federal Reserve official helped draw a line, for now, under the recent plunge in Treasury yields.
The yield on two-year Treasury notes climbed as much as 9 basis points to 2.95%, before moving back to around 2.91%.
Already up on the day, the rate climbed to a session high after data from the US personal income and spending report showed the PCE deflator -- a gauge that the Fed watches -- climbing 1% month-on-month, more than the 0.9% median estimate of economists. Earlier, Atlanta Fed President Raphael Bostic said the US economy was “a ways” from entering a recession and the central bank had further to go in raising interest rates to get inflation under control.

The End of Super-Sized Rate Hikes

Market participants were looking for something that could be called a policy pivot, and the Fed delivered. As we expected, the Federal Reserve Chair Jerome Powell opened a path to stepping down from 75bp hikes while at the same time making clear that the Fed will keep hiking policy rates. Market participants focused on the first half of the story, not surprisingly because Powell fed into the market’s current mood by highlighting signs of slower growth. Although Powell did not provide firm guidance for September, we think the Fed will hike 50bp. Rate hikes will continue until the inflation data provides a path to restoring price stability.

The first two lines of the FOMC statement set the stage for Powell’s press conference:

Recent indicators of spending and production have softened. Nonetheless, job gains have been robust in recent months, and the unemployment rate has remained low. 

While the job market remains solid, the Fed sees that growth is slowing, and that slowing is a precursor to the softer labor market the Fed is trying to engineer. The Fed needed to find a path to step down from 75bp, and slower growth provided that path.

Powell confirmed that the Fed was looking forward to slowing the pace of rate increases during his opening statement:

Over coming months, we’ll be looking for compelling evidence that inflation is moving down, consistent with inflation returning to 2%. We anticipate that ongoing increases in target range increases for the federal funds rate will be appropriate. The pace of those increases will continue to depend on the incoming data and evolving outlook for the economy. Today’s increases in the target range is the second 75 basis point increase in as many meetings. While another unusually large increase could be appropriate at our next meeting, that is a decision that will depend on the data we get between now and then. We will continue to make our decisions meeting by meeting and communicate our thinking as clearly as possible. As the stance of monetary policy tightens further, it’ll become appropriate to slow the pace of increases while we assess how cumulative policy adjustments are affecting the economy and inflation. 

To be sure, Powell did not provide hard guidance that the Fed would step back to 50bp in September and kept the 75bp option on the table, the final sentence tells us that although they are looking for compelling evidence the inflation is falling, the Fed will balance inflation against growth when assessing the size of any individual rate hike. In other words, the Fed will keep hiking rates, but assuming growth slows as expected, the Fed will scale back the size of rate hikes as it feels around for the terminal rate. We probably need to see even worse inflation numbers in the context of reaccelerating growth to push the Fed into another 75bp. This is certainly possible, but not likely. Still, the risk of another 75 is greater than a drop to 25.

Powell made clear that inflation was the Fed’s priority even if that requires a period of weak economic growth. From the opening statement:

Our overarching focus is using tools to bring demand into better balance with supply in order to bring inflation back to our 2% goal and keep longer term inflation expectations well-anchored…We are highly attentive to inflation risks and determined to take the measures necessary to return inflation to our 2% longer run goal…This process is likely to involve a period of below-trend economic growth and some softening in labor market conditions. Outcomes are necessary to set the stage for achieving maximum employment and stable prizes over the longer-run. 

Also, later when questioned about the Fed’s pain point for unemployment that would trigger a rate cut, Powell said:

We’re going to be looking at inflation as well. We — as I mentioned, we need to see inflation coming down. We need to be confident that inflation is going to get back down to mandate consistent levels. That’s not something we can avoid doing. That really needs to happen and we do think that the labor market can adjust because of the huge overhang of job openings of excess demand, really. 

Moreover, he leaned into the June SEP more than once, which was arguably strong pushback against market pricing going into the meeting that expected rate cuts next year:

I think you can still think of the destination as broadly in line with the September — sorry, the June SEP. It’s only six weeks old. Sometimes SEPs can get old really quick. I think, in this one, I’d say, it’s probably the best guide we have as to where the committee thinks it needs to get at the end of the year and into next year. I’d point you to that.

Citing the June SEP is consistent with our “higher for longer” rate story. The Fed might see slower growth as a reason to step down the pace of rate hikes but needs substantially lower inflation to cut rates. FOMC participants don’t anticipate pausing or cutting quickly in response to slowing growth alone. Powell also perhaps inadvertently nodded to a 50bp hike in September by pointing to the June SEP as a guide. A 75bp rate hike would be consistent with a rising estimate of the terminal rate, whereas 50bp is more consistent with the June SEP.

But despite Powell emphasizing inflation concerns and the June SEP, markets moved in the opposite direction, pricing in a terminal rate of just 3.3% at the end of this year. This did not surprise us. We thought market participants would see stepping down from 75bp as a dovish pivot, and that Powell’s emphasis on slowing growth would intensify that view. It was almost unavoidable really. Market participants expect the Fed will prioritize growth concerns, and the Fed appeared to confirm that today.

Still, while we expected a dovish takeaway, the degree to which Powell reiterated the slower growth story caught our attention. This may simply have been an artifact of the nature of the questions as journalists pressed Powell on slowing growth and recession risk, but there was a sense that Powell was less committed to risking a recession if necessary to restore price stability. I wrote earlier this week that I am only 80% confident the Fed follows through on its intention to delay rate cuts until inflation was clearly closer to target on a sustained basis, and this performance didn’t move me any closer to 100%. As we always say, it is easy to talk tough when unemployment is around 3.6%, but it won’t be so easy when unemployment is rising. At the risk of reading too much into a one day move, I sense that is what market participants picked up today.

That said, we don’t really think the Fed is any less committed to restoring price stability. After all, the Fed expects that it will continue to hike into what it sees as a slowing economy. That is certainly hawkish relative to past behavior and speaks to the elevation of inflation concerns in the Fed’s reaction function. Moreover, as we said, Powell may have been pulled in a seeming dovish direction by the nature of the questions. I suspect that the Fed will be unhappy with the new market pricing and the implied easing of financial conditions, and we will see speakers push a hawkish story in coming days. Still, it may be hard to convince market participants that the Fed remains focused on inflation until the Fed hikes after the unemployment rate ticks higher. In other words, actions speak louder than words.

Bottom Line: There is a palpable sense of relief in markets that the big rate hikes are behind us and now we can look forward to the eventual rate cuts while ignoring the remaining rate hikes in this cycle. That sense of relief drove an even greater wedge between market pricing and the Fed’s expected rate path. That wedge needs to be resolved in the coming months, and the Fed is telling us that unless it sees a compelling drop in inflation, it expects market participants will need to move in its direction.

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