Fed May Have Just Two Hikes Left, SocGen Quant Suggests

Market pricing for Fed hikes went into overdrive late last week, when tail hedges for 75bps hike increments showed up on radar screens.

The dramatic escalation in rates suggested traders aren’t convinced the front-end selloff has run its course, nor are they convinced enough rate hike premium is built in.

But to say some are skeptical of the economy’s capacity to absorb ~250bps of hikes in 2022 alongside the tightening impulse from balance sheet runoff would be an understatement. The advance read on Q1 GDP (due later this week) is guaranteed to show momentum decelerated sharply over the first three months of the year (figure below).

With consumers already squeezed by generationally high inflation, a Fed that delivers the most acute blast of monetary tightening in decades risks choking off growth entirely.

Maybe that’s the point. Maybe Jerome Powell really is keen on demand destruction. But I, for one, doubt the Committee’s fortitude in that regard. At the least, this Fed’s stomach for collateral damage on Main Street is weaker than the Volcker Fed’s.

On multiple occasions over the past two months, SocGen’s Solomon Tadesse suggested that if one considers the cumulative tightening impulse from rate hikes and balance sheet runoff, the read-through is that the Fed is unlikely to deliver anywhere near the number of outright hikes priced by markets. His well-known colleague, Albert Edwards, suggested the Fed will likely have trouble sustaining a policy rate beyond 1%.

Read more:

Why The Fed May Only Deliver Half Its Planned Rate Hikes

Albert Edwards: ‘Fed Funds Won’t Rise Beyond 1%’

In a new note, Tadesse updated his analysis, which he said “suggests that the current Fed monetary policy cycle could peak at a mix of a moderate policy rate hike of about 0.75-1pp and an additional implicit monetary contraction from QT of about 220bps, which could be accomplished through asset runoffs of as much as $1.8 trillion.”

As a reminder, Tadesse utilizes a ratio of tightening to easing (MTE), which has trended lower over time. Effectively, subdued inflation made it possible for policymakers to undershoot previous easing efforts in subsequent tightening campaigns. A ratio below one means (by definition) that policy trends easier over time.

In his latest, Tadesse reminded readers that shadow rates have already tightened significantly from cycle lows. “Rates are up by 250bps, reflecting Fed balance sheet tapering and anticipation of rate hikes,” he wrote, adding that,

Given the structural shift in monetary policy, the best reference for evaluating the current state is the experience in the post-inflation era since the mid-1980s. MTEs over this period have been relatively stable, ranging from 52% (in 1989-2000 cycle) to 77% (in the 2000-07 cycle), with average MTE of 69%. The total degree of monetary easing during the previous monetary easing phase, including the large liquidity injections from the pandemic-fueled QE, amounts to about 7.90%. Thus, to reach the average MTE ratio of the last four cycles in this tightening cycle, policy would call for a total tightening of about 542bps (0.69 x 7.90%) from the last trough. Given that the shadow rate has already gone up by 2.50pp so far, it can be argued that we would need an additional overall monetary tightening of about 300bps (2.92%) to achieve the average peak of rate cycles observed in the post-stagflation era of the Great Moderation.

That’s the gist of the argument. The implication, obviously, is that if the Fed were to deliver on market pricing for ~250bps in outright rate hikes alongside balance sheet rundown, policy would materially overshoot the tightening impulse typically associated with Great Moderation-era cycles this year.

It’s possible they intend to do just that. The Fed’s credibility on the inflation front is in tatters, and they’re keen to reclaim it. Just as there are multiple policy conjunctures which could add up to the additional 300bps of tightening SocGen’s model says is consistent with post-1984 cycles, so are there any number of combinations that could result in a restrictive policy stance that risks recession in the service of fighting inflation.

The figure (below) is Tadesse’s “Monetary Policy Frontier.” The red line shows different policy mixes which would all equate to 300bps in additional overall tightening.

The framework, Tadesse wrote, is “analogous to traditional technology (such as cost or production) frontiers” in that it “defines the feasible set of policy actions available to policymakers given exogenous constraints including desired levels of price stability, growth path, market expectations, government financing considerations and others.”

The green star (“likely mix”) in the figure corresponds to 80bps of rate hikes and $1.8 trillion in QT. If you trace the red line backup the frontier, you can see that such a mix would induce the same amount of overall tightening as, for example, 275bps of hikes and $140 billion of QT.

The implication from this exercise is that if the Fed intends to meaningfully trim the balance sheet, the room for rate hikes is severely constrained. Tadesse conceded that “ongoing inflationary pressure could… requir[e] more tightening than suggested by our model,” but that would chance a recession.

“Our analysis based on historical data suggests that any combination of policy moves that pushes the overall monetary policy stance beyond the MPF would risk inducing a hard landing with severe market reaction and economic downturn,” he said, calling a policy rate path that includes an additional 75-100bps in rate hikes coupled with around $1.8 trillion in QT “more likely.”

Coming full circle, traders were hedging multiple 75bps hikes late last week on the heels of Jim Bullard’s trial balloon and Powell’s endorsement of a front-loaded cycle. If Tadesse’s analysis is correct, and assuming the Fed intends to trim the balance sheet by at least $2 trillion, a single 75bps move, or two 50bps moves, would exhaust the Fed’s policy room on the rate hike side.