Mission Impossible: What To Expect From The Fed

All eyes turn to the Fed in the new week.

Not that traders weren’t already obsessing over the September policy decision. Day after agonizingly tedious day, every discussion pivots around the size of the next rate hike and, more importantly, the Fed’s destination and how long they’ll linger once they reach it.

Last week was defined by a repricing (higher, obviously) of the terminal rate and speculation on the prospect of a full-point move at the September FOMC. Personally, I doubt they’ll opt for a 100bps hike, but I’ve been wrong before. There were no “wink, wink” media stories to suggest the Committee was leaning definitively in the direction of a bazooka shot. “Fed whisperer” Nick Timiraos said only that August’s CPI report “clinches the case for the Fed to lift interest rates by at least 75bps.” The “at least” bit left the door open, but soft core retail sales and a relatively benign read on University of Michigan inflation expectations may mean the “totality” of the data (to adopt Powell’s latest buzzword) doesn’t quite tip the scales in favor of an all-in move.

To be sure, there’s a case for moving in even larger increments. Inflation is triple or quadruple target, depending on your preferred measure of price growth (as Powell emphasized earlier this year, regular people don’t care about core). Food and electricity prices are rising at a double-digit annual rate. Shelter costs are rising at a 6% 12-month pace. Rate hikes can’t address supply factor-driven inflation. But optics are important. And the only thing larger than the disparity between inflation and the Fed’s target is the Fed’s credibility deficit. Maybe the Fed is credible again to markets and pundits. Breakevens are tame, for example. But I can assure you that the Fed, like every other American institution, is on thin ice with an aggrieved electorate.

The dots will obviously need to shift higher. It wasn’t so long ago when Powell was still referring inquisitive reporters to the June SEP when queried on where officials see rates headed, but in light of recent developments on the data front, Fed speak and market pricing, the June dots are too low. Rates are generally seen peaking at around 4.5% early next year. The new dots will reflect consensus among most officials for a terminal rate in excess of 4%. “With the sharp rise in the market pricing of the terminal fed funds, we expect the Fed to increase its projections for the fed funds rate for this year and next year in the September SEP,” SocGen’s Subadra Rajappa said.

The tension between markets and the Fed isn’t so much about the peak for rates as it is about the Fed’s resolve to hold terminal. The Fed is determined to dispense with the idea that rate cuts are likely in 2023. Markets aren’t convinced. Official after official has pushed back in unequivocal terms on the notion that a pivot is less than a year away. Fed pricing has firmed up a bit. The figure (below) does represent a pretty hawkish outcome even if the Fed would rather markets not speculate on cuts in H2.

The cruel irony for the Committee is that the harder they push the “restrictive for longer” line, the more convinced the market is that a hard landing is assured. The higher the odds of a hard landing, the higher the odds of a pivot. This is yet another example of why officials might be better served by saying (a lot) less in public.

It’ll be very difficult to dislodge expectations for rate cuts in the second half of next year. At the same time, bets on even higher rates (e.g., ~5%) and other very hawkish expressions (e.g., rates at 4.5% at year-end 2023) proliferated last week. When juxtaposed with generalized expectations for easing commencing mid-year, you’re left with the impression that markets see the Fed’s pretensions to fortitude as a tail risk, not a credible promise — it’s prudent to hedge the possibility that officials summon the courage to hold terminal until inflation waves the white flag, but four decades of growth-conscious monetary policy suggests the first negative NFP print will compel a rethink.

BMO’s Ian Lyngen and Ben Jeffery expect terminal has been upped to 4.25%-4.50%. “Other updates from the Fed will indicate the Committee intends to retain a restrictive policy stance for longer during this cycle than the average time at terminal of seven months would imply,” they said. “Whether this translates to 2023 and 2024 funds projections at the same level is a wildcard given the June SEP showed the former 40bps above the latter,” they added. “Said differently, it’s well within the set of conceivable outcomes for the FOMC to indicate 24 months at terminal.”

That’d represent a very large disconnect with market pricing. But it’d hardly be surprising. The Fed is keenly aware that many (most) observers expect a repeat of the 70s. Powell now habitually references the lessons learned from America’s last serious bout with inflation, and has repeatedly pledged to persist until the job is well and truly done. He’ll doubtlessly repeat some version of that pledge this week, during the press conference.

Fed critics (a group which includes former Fed officials, both high ranking and otherwise) will mercilessly deride the updated projections for the unemployment rate. In June, the SEP reflected a begrudging acquiescence among policymakers that the jobless rate will have to rise at least a little bit (figure below).

Since then, officials have gingerly conveyed the same message in public, culminating in Powell’s “some pain” remarks in Jackson Hole.

But there’s no chance (none) that the new SEP will convey anything like the kind of rise in unemployment critics insist will ultimately be “necessary” to tame inflation. So, whatever the new projections for the jobless rate are, they’ll be widely panned as naive.

As for the growth and inflation projections, expect the same dynamic. Critics will insist the inflation forecasts for 2023 and 2024 (whatever they are) are too optimistic, and the growth outlook will be lampooned for failing to recognize the purported “necessity” of a recession.

Of course, a lot of that criticism will be disingenuous, even as those doing the criticizing might fairly contend that they wouldn’t have to be disingenuous if the Fed would just be realistic. So, for example, if the Fed were to project an unemployment rate of, say, 4.7%, and an anemic pace of expansion, critics might cut them some slack. Something like this: “Well, these forecasts are about as honest as you could reasonably expect considering the source.” Instead, markets will be treated Wednesday to a set of projections with almost no hope of being borne out, and as absurd as this most assuredly is, it’s entirely possible that the growth projections could clash with the Fed’s own contention that policy is now explicitly aiming to engineer “a sustained period of below-trend growth,” as Powell put it late last month. There’s no chance the growth outlook will reflect anything like a meaningful recession.

“With the market already priced for additional hawkishness, we believe the market’s focus will fall on the size of the hike, the terminal rate, the tone of the press conference and the 2023 dot,” TD’s Priya Misra wrote. “A higher terminal rate projection could suggest that markets may have further to reprice [and the] 2023 distribution will also be key in terms of how many dots are above 4.5%,” she went on to say, adding that the bank expects the 2024 dot to show the start of Fed easing and “the new 2025 dots to continue to show easing to 2.875%. “The speed and magnitude of cuts penciled in could be market moving,” Misra wrote.

As for any pretensions the Fed might (claim in public to) harbor about holding terminal through 2024, BMO’s Lyngen said there’s “very little chance the Committee will be afforded the ‘Goldilocks,’ soft landing to make such a path for fed funds possible.”

But this is a Fed that’s obliged to put on a brave face. And, as Lyngen went on to point out, the dots are “a ‘low cost’ method for reinforcing [a] hawkish stance for 2023.” “Despite the number of Fed officials who have downplayed the importance of the dots, market participants continue to derive trading direction from the updates and therefore it’s very difficult to fade them,” he added. BMO expects “a hawkish maelstrom on Wednesday.”