The Short Road To A Policy Error

Jerome Powell may have officially “retired” the word “transitory” as a description of elevated inflation late last month, but that doesn’t mean it won’t come up in the new week.

Reporters will surely berate Powell in the public interrogation following the December FOMC meeting, and part of that ritual grilling will entail mocking queries about why the Fed failed to see the writing on the wall and whether policy is now so far behind the curve that aggressive rate hikes might be necessary in 2022 in order to arrest rising prices.

November’s CPI data wasn’t as bad as feared (despite being the highest in decades, the headline YoY prints were in line with market expectations), but the political optics were daunting enough to prompt the Biden administration to embark on a two-day media blitz aimed at emphasizing the “backward looking” nature of the numbers.

Notably, the gap between the Cleveland Fed’s trimmed gauge and core CPI is now the narrowest since the latter began to significantly outpace the former earlier this year (figure below).

“The much-maligned ‘transitory’ word will likely be ‘retired’ from the statement, but with officials making clear that they still expect inflation to slow significantly when upward pressures from COVID-related developments ultimately subside,” TD’s Jim O’Sullivan and Priya Misra said, on the way to suggesting that Omicron isn’t likely to have materially altered the baseline outlook of policymakers, even if the statement language acknowledges higher risks and uncertainty.

“Officials could tweak the forward guidance on liftoff to raise the possibility of rate hikes even before ‘maximum employment’ is reached, with flexibility potentially needed to prevent long-term inflation expectations from rising excessively,” they added.

That’s not ideal. It would be a tacit admission that the Fed has been forced into prioritizing the inflation fight at the possible expense of jobs. The refrain from Powell (and others) has consistently emphasized the necessity of not “leaving workers behind.” And there are still millions who were working in February of 2020 but aren’t working now. Needless to say, not all of them retired.

The story is the curve. There’s a compelling argument for flattening pressure from both ends. The short-end from the perception that the Fed will bring forward hikes and the long-end from concerns about the impact of an accelerated tightening cycle on growth. Potential Omicron “drag” (so to speak) is another excuse for the long-end to rally or, at the least, for any rise in long-end yields (e.g., if oil starts climbing towards $100 again, if PCE accelerates more sharply than expected or if there’s movement on The White House’s social agenda) not to keep pace with the selloff in fives (for example).

“Confirmation that the Fed is onboard with the market’s pricing of at least two hikes next year will keep the front-end of the market under pressure and further contribute to the momentum favoring ongoing flattening,” BMO’s Ian Lyngen and Ben Jeffery said. “The bulk of the surprise risk will be absorbed by the five-year sector as the perception remains that if the Fed doesn’t bring forward hikes then it will slip further behind the curve and ultimately need to tighten more aggressively to keep inflation expectations anchored.”

The 5s30s managed to poke its head back above 60bps late last week, but it wouldn’t be surprising (at all) to see the curve revisit recent tights.

“The yield curve looks set to be the flattest at the beginning of a Fed tightening cycle in a generation,” Bloomberg noted, citing the 2s10s. “Unless inflation or long-term rates change dramatically, the curve suggests a series of Fed hikes in 2022 could cause an inversion.”

It’s very difficult to see how policymakers can possibly thread the needle absent a material deceleration in inflation starting in Q1. To be sure, that is the consensus outlook (figure below), but forecasters don’t have the best track record in normal times, let alone during periods of extreme uncertainty tied to exogenous shocks emanating from outside the world of economics and finance.

The new dots and SEP will have to be marked to market. The inflation projections for obvious reasons and the dots to both acknowledge the possibility that rate hikes will be needed sooner and to align with an accelerated taper timeline (belabored attempts to “de-link” liftoff notwithstanding).

Officials aren’t likely to coalesce around a view of liftoff beginning as soon as the taper is finished (likely in March under the expected new schedule, as illustrated in the figure below). But you’d expect to see some pull-forward reflected in the dots, and that, in turn, will stoke speculation about how long the Fed will wait after the taper ends to pull the trigger given that, even under relatively benign scenarios for CPI, inflation will still be elevated well into next year.

An announcement of an accelerated taper is a foregone conclusion. I’m not sure any major bank believes the Fed will wait to announce a faster pace.

“Even if the dots show two hikes as a median, a large number of FOMC members expecting three hikes in 2022 could leave the market pulling forward hikes further,” TD wrote late last week.

“Given the composition of the September SEP, it’s a foregone conclusion that the 2022, 2023 and 2024 fed funds projections will be higher than the respective levels of 0.3%, 1.0%, and 1.8%,” BMO’s Lyngen said. “The more relevant questions are related to the slope and the terminal rate.”

Ultimately, the debate will continue to revolve around the apparent disagreement between the market and the Fed on the likely outcome of rate hikes to control inflation. The market’s focus on the short-term reflects both ambiguity around the more distant future (largely unknowable given pandemic cross currents and the longer run consequences of unprecedented stimulus) and the attendant focus on Fed policy as the only thing to which odds can be assigned.

“The market [may have] its own interpretation of the future, most likely distinct from the Fed, except in the near-term,” Deutsche Bank’s Aleksandar Kocic wrote, in his latest, documenting an anomaly in the Eurodollar curve which he described as “largely driven by the market’s abdication to take a view and get directly involved with the long-term forces, which have been eluding us since the beginning of the year.”

The figure (above, from Kocic) gives you a sense of things. Even if it’s not immediately recognizable to the layperson, the chart header tells the story.

“The repricing of the front contracts is consistent with frontloading of the Fed hikes, while the actual decline of the long end beyond 2Y1Y forwards reflects a lack of conviction regarding validity of that maneuver,” Kocic remarked.

Also on deck in the new week stateside: NFIB, PPI, retail sales and regional Fed surveys.

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6 thoughts on “The Short Road To A Policy Error

    1. If they tip the economy over enough so that demand for labor plunges so that those lazy bum workers stop demanding wage increases and settle for the overly-generous minimum wages.

      But, as noted previously by Dr. H, pundits and prognosticators are reluctant to spell that out to the general public.

      1. Sir: I generally appreciate your comments on this site but respectfully, can you live off the “overly-generous” minimum wage? Even $15/ hour gives one only a 30k gross paycheck for full-time work. In my metro area in KC, the average 2-BR apartment goes for 1700/mo. That’s 2/3 of those generous wages and there’s not much left for food, gas, health care, and the all important phone.

    2. Your question calls us to recall times when a couple quarter percents in rates were not a big deal. If rates were 5%, a quarter of a percent up or down would be a small difference to the prevailing rate. And yes, with a Fed Funds rate at 0.25, a quarter percent hike is effectively doubling the rate. But that’s not the point.

      Traditional theory posits that rate hikes increase the cost of borrowing and (incrementally) disincentivizes borrowing (aka capital expenditures/new debt). But when corporate debt is high (as it is now), an increase in the cost of rolling over debt is a drag on profit. The effect of increases in borrowing costs on corporate profitability enlarges with the amount of debt.

      So when companies spend less on growing, unemployment goes up. When that happens, workers can’t demand higher wages and can’t afford to pay inflated prices. That’s the crux of how rates affect inflation (as long as it is demand-driven inflation). At least, that’s my take on it.

      Your question speaks to the opiate addiction metaphor in the post. Over time, markets (like addicts) become more intolerant to disruptions to their access to ‘the juice’ (low rates). But that’s beyond the scope of your question.

  1. H-Man,

    So using football speak, Powell is at third and 20. He has to throw a dart. He misses but how much time on the clocK? Hail Mary?

NEWSROOM crewneck & prints