Who Are You, And What’ve You Done With The Fed?

Try as US policymakers might to disabuse traders of the notion that peak Fed funds will be followed by outright easing in relatively short order, the market will almost surely continue to assign some probability to rate cuts in the back half of 2023.

It’s the legacy of a Fed that spent most of the last four decades in growth-conscious mode, yes, but more than that, it’s extreme recency bias on the part of market participants, many of whom have never known anything other than a Fed that’s protective of risk assets.

Lehman was 14 years ago, believe it or not. I still remember precisely where I was when the fate of the financial universe hung in the balance, but not everyone on Wall Street does. A meaningful number of analysts, strategists and traders were in high school at the time. Their entire professional careers were spent in what Deutsche Bank’s Aleksandar Kocic has described as a “state of exception,” a reference to martial law in the political context. For that contingent, aggressively hawkish central banks is an entirely new experience.

The macro regime that prevailed from late 2020 through midyear 2022, characterized as it was in most locales by ever higher inflation (figure below) and, in some countries, very hot nominal growth, is totally alien to that same cohort of market participants.

That conjuncture (very high inflation and hot nominal growth) hasn’t existed in an across-the-board, sustained sense since the onset of The Great Moderation, which predates the entire lifespan of today’s youthful traders and macro analysts.

This sets the stage for tension in 2023. Tension between, on one hand, a market accustomed to pivots at the first sign of trouble on the growth front and, on the other, a Fed likely to insist on holding terminal for as long as absolutely possible given not just the difficult math around getting inflation back to target, but the risk of easing prematurely only to see inflation reaccelerate.

Remember: All it took was one relatively cool CPI print to spark the third-largest easing impulse on Goldman’s gauge of US financial conditions ever (figure on the left, below).

The figure on the right (above) shows the index itself, along with the rolling one-year impulse (i.e., the shaded area illustrates the ebb and flow).

Regular readers have seen those visuals before, but I often find it helps to reiterate key points by way of side-by-side charts depicting the same dynamic.

The Fed is keen to preserve the tightening achieved in 2022, and will be loath to relinquish it until the coast is well and truly clear on inflation. While traders (i.e., market pricing for the rate path) are unconvinced, strategists are converts. The Fed’s message is at least resonating with Wall Street’s analysts. The read-through is that for many, next year could be an arduous, frustrating affair characterized by stubborn policymakers who, fearing a rekindled inflation impulse, refuse to budge — even in the face of recession.

That was the overarching message from Barclays’ Ajay Rajadhyaksha, who began the bank’s quarterly outlook by referencing the dramatic easing impulse illustrated by the visual on the left (above). “As we sat down to write this quarterly last week, financial markets were rejoicing over a weaker-than-expected US CPI report,” he said. “But a quarterly publication is a time to pull back from near-term data and look at the bigger picture, and in the larger scheme of things, one CPI print does not a trend make, especially when US inflation has flattered to deceive in the past.”

Rajadhyaksha went on to emphasize just how frantic the rate hikes were across locales this year, calling the cumulative impulse “an enormous amount of monetary policy tightening. In a very short time.”

That’ll be the story of 2023, if you ask Barclays. “What matters more than the latest inflation print in our view is the impact of 2022’s hikes,” Rajadhyaksha wrote, adding that (abridged),

The hikes of 2022 will be the most important factor for global growth in 2023. Monetary policy works through long and variable lags. With the exception of housing, where activity has taken a big hit (especially in the US), policy tightening has not had enough chance to affect large parts of the economy. That will change next year. We expect developed economies to contract across calendar year 2023. Taken together, our new global growth forecast for 2023 reaches only 1.7% YoY, almost half the 3.2% YoY we predict for 2022, and almost a fourth of the pace of 2021. With the exception of the GFC recession and pandemic-struck 2020, this would be the slowest year since 1982. As importantly, we expect prices to fall at a slower pace than growth.

The rest writes itself. Growth will slow rapidly, inflation will slow too, only not so rapidly, which means policymakers will be in a bind.

Markets still seem to believe that when faced with recession, the Fed is guaranteed to blink. Analysts and macro strategists aren’t convinced anymore.

“The endless debate over the peak policy rate misses this important point,” Rajadhyaksha said. That point: A “pause” isn’t a “pivot.”

“What matters more than the peak, in our view, is that rates will be high even with advanced economies in a recession,” Barclays cautioned. “Inflation might fall, but not quickly enough to allow officials to ease quickly.”

If that turns out to be the case, there are going to be a lot of frustrated twenty- and thirtysomethings wondering who these people are, and what they did with the market-friendly Fed.