108 To 2

During last month’s policy deliberations, “many” Fed officials voiced some concern around the risk of over-tightening.

Considering the “constantly changing” macro environment, and the lagged nature of monetary policy’s effects on the economy, policymakers worried they might inadvertently overdo it — that the Committee “could tighten the stance of policy by more than necessary to restore price stability.”

That was one notable takeaway from the account of the July FOMC meeting, during which the Fed opted for a second consecutive 75bps rate hike. During remarks to reporters following July’s gathering, Jerome Powell accidentally gave equities an excuse to extend a burgeoning rally. Powell’s allusion to the proximity of the neutral rate along with the misperception of a dovish slant, bolstered risk sentiment. Three weeks and one cooler-than-expected CPI report later, and US stocks were eying a new bull market, as absurd as that most assuredly sounds.

There was broad-based support for front-loading among officials. Considering the scope of the inflation overshoot and “upside risks,” the Committee generally supported “moving to a restrictive stance of the policy rate in the near-term” as part of an effort to prudently manage risk and “better position the Committee to raise the policy rate further” in the event inflation proved obstinate or, worse, accelerated further. Put differently, the Fed wants to get ahead of the curve — they want to be in restrictive territory sooner rather than later so that, should conditions warrant, they can really tighten the screws.

The juxtaposition between, on one hand, concerns about over-tightening given the ambiguity inherent in “long and variable lags,” and, on the other, a desire to get beyond neutral expeditiously in order to ensure policy isn’t contributing to any additional inflation overshoot, is a testament to the two-way risk confronting the Committee. Rates may already be too high and they wouldn’t know it. But, depending on a hodgepodge of factors, some of which are completely beyond the Fed’s control, hindsight may show that policy needed to be far tighter.

Spoiler alert: There’s no “right” answer. There’s a very real sense in which no one will ever know the answer given that the Fed’s capacity to control inflation driven by supply factors is limited.

July’s CPI report was a good example. Fed hikes had little, if anything at all, to do with the cooler-than-expected print. Officials would likely quibble with that assessment, but the Fed’s own measures of “sticky” inflation and gauges designed to strip away “outliers,” hit new highs (figure below).

The minutes noted that “the course of inflation [will] be influenced by various non-monetary factors, including developments associated with Russia’s war against Ukraine and with supply chain disruptions.” They probably could’ve replaced “influenced” with “dictated.”

The give and take is really between the perceived necessity of keeping rates in restrictive territory for “longer” (whatever that ends up meaning) and the self-evident conclusion that eventually, the pace of rate hikes will slow.

“Participants judged that, as the stance of monetary policy tightened further, it likely would become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation,” the minutes said.

Again, that’s not “dovish” as much as it is a statement of the obvious. Plainly, the Fed won’t keep hiking by 75bps or 50bps forever. Eventually, Fed funds would be 20% and the economy would be in a depression. So, yes, the pace of hikes will absolutely slow at some point, probably next month when, barring a re-acceleration in CPI for August, a surprise in July’s readings on PCE prices or some manner of ultra-hot read on average hourly earnings accompanying August payrolls, the Fed may downshift to 50bps.

What happens after that is anyone’s guess. One thing that almost surely isn’t going to happen, though, is a rate cut in Q1 2023. “‘Past peak hawkishness’ does not mean ‘easier,'” Nomura’s Charlie McElligott emphasized on Wednesday. “Markets increasingly need to adjust to a worldview where the Fed is going to run higher- / tighter- / more restrictive- for longer,” he added, noting that market pricing has now completely removed what he called the “preposterous” 25bps cut priced in last month, when the growth outlook deteriorated (figure below, with Charlie’s annotations).


As discussed at some length in “Inflation Left-Tail Is Dying, But Hold The Champagne,” falling odds of a nightmare scenario in which US inflation becomes truly unanchored doesn’t mean the Fed has carte blanche to call it a day. Not even close. Once the risk of an EM-style spiral is snuffed out, they’ll need to ensure the public gets the message, and even if policymakers get any “bad” ideas about a premature pivot, “sticky” components will likely keep inflation running well above target as a reminder that the job is far from done.

The July minutes alluded to, and in some cases directly addressed, all of those points. “Some participants indicated that, once the policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time to ensure that inflation was firmly on a path back to 2%,” the account of last month’s meeting read.

As for the above-mentioned nightmare scenario, Fed officials still described the loss of public confidence as a meaningful concern. “A significant risk facing the Committee was that elevated inflation could become entrenched if the public began to question the Committee’s resolve to adjust the stance of policy sufficiently,” the minutes read. “If this risk materialized, it would complicate the task of returning inflation to 2% and could raise substantially the economic costs of doing so.”

It was plausible to suggest the minutes skewed dovish. In addition to mentions of over-tightening risks, “a number” of officials said “some of the effects of policy actions and communications were showing up more rapidly than had historically been the case.” They attributed that to the rapidity of rate hikes and, amusingly considering their own erratic messaging, “supporting communications,” which together have “already led to a significant tightening of financial conditions.”

There were two mentions of “recession,” one of which was unrelated to policy (the word came up in the discussion of bank stress tests). The word “inflation,” by contrast, featured 108 times.

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8 thoughts on “108 To 2

  1. “What happens after that is anyone’s guess”.

    Isn’t that the point of being data driven? We don’t know enough stuff yet. Don’t know what inflation will print. Don’t know what the real impact of doubling QT will be in September. Don’t know a lot. So you trade what’s visible. The play by play commentary is both what makes your musings so incredibly enjoyable, but also just constantly reinforces that markets are making it up as we go along. Be careful out there!

  2. Minutes sound more dovish than post-presser comments. Also sounds like Powell’s presser comments were pretty faithful to the FOMC’s discussion.

    My impression is the Fed wants to get a bunch of hikes in quickly, hoist FF to what it considers restrictive (mid 3s?) before end 2022, then if inflation has settled into a moderating path, pause and see if the lagged effects of hikes, the growing effects of QT, and maybe a bit of luck on external forces, pull monthly core and headline inflation to the desired level. I do not get the sense the Fed is desperate to get 2022’s annual inflation to some arbitrary backwards-looking number.

    So suppose we enter 2023 with FF 3.50, 2 year high 3s, 10 yr low 3s (inverted 50+ bp).

    That’s not great for long duration assets (if discount rate has to add back the bp shed in July) but those still seem to me like pretty un-intimidating interest rates (historically speaking).

    1. hi jyl, agree with your “impression”.

      My best guess now is, if something breaks in 2023, lingering inflationary pressure would mean no rate cut (or at most one at 25 bps, effect of which likely only through sentiments channel), but potentially dial-down of QT to stabilize USTs. Or other new Fed facilities to ease the pain in the real economy, skipping the textbook interest rates channel.

      And the bigger question down the road: what will be the next policy innovation in a stagflation scenario (after QE, credits backstop, ECB’s NIRP, BOJ’s YCC, i vaguely recall there was also temporary overdraft at BOE)? Will there be meaningful evolution of MMT-informed Treasury-Fed “coordination” going forwards?

      If Pozsar/Blackrock, etc. are right about structurally higher inflation in the medium term ahead, 10yr UST yield may only have a few more dives to mid 2s during event/data shocks, before the “persistent inflation” camp goes mainstream and establishes yields uptrend in the years ahead.

  3. Energy seems like A if not THE monkey wrench here. If the rapid fall in energy prices is the basis for the flat MoM inflation print we may need other factors to take the baton going forward.

    Eia had an absurd inventory print today and last weeks gasoline print was eye opening as well.

    1. I sold a whole bunch of energy weight in the spring, but have been holding on to an above-benchmark weight through the summer. It seems like energy should be a play on a shallow-not-deep recession. That hasn’t been working, but the various inventory data keep me stubborn.

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