Ahead of the pre-meeting quiet period, Fed officials have another week to push back on mounting suspicion that the most aggressive hiking cycle since Jerome Powell was a young man is nearing its end and may go into reverse later this year.

Although policymakers continue to insist that the peak for Fed funds is likely above 5%, markets aren’t convinced. Following another relatively favorable CPI report, some began to ponder a pause as soon as March.

The official rhetoric has softened at the margins. Officials (some of them, anyway) openly favor another step down (i.e., to 25bps) at the February gathering, but the Committee seems intent to hold the line when it comes to their 5% terminal rate ambitions and particularly the notion that rate cuts aren’t forthcoming this year.

The market now sees rates peaking around 4.9%, has slightly less than 50bps priced through the March meeting and still sees around two “regular”-sized cuts by year-end. Following November’s FOMC meeting, and prior to the release of October’s cooler-than-expected CPI report, the market was generally on board with the “higher for longer” narrative, albeit with cuts still priced for the back half of 2023.

“The debate remains whether Powell is able to execute the full 75bps of additional tightening reflected in the SEP or be limited to the ~50bps reflected in the futures market,” BMO’s Ian Lyngen and Ben Jeffery remarked. “It goes without saying that the Committee envisions a longer stay at terminal than investors are anticipating and to the market’s defense, the Fed has a well-established track record of spending a briefer time at terminal than it’s currently signaling.”

Labor market resilience threatens to keep wage growth uncomfortably high, and it’s certainly possible that elevated pay growth against moderating inflation could translate to resilient consumer spending. In theory, that could complicate the Fed’s efforts to get inflation all the way back down to 2%. The preliminary read on University of Michigan sentiment for January underscored that “threat,” with the scare quotes to remind readers that 2% is a totally arbitrary number. If wages are growing in real terms, consumers feel good about things and price growth is, say, 3.5%, it’s not entirely obvious why 2% is preferable. If you’re allergic to any and all inflation, then let me ask you this: Why not 1.5%? Or 1%?

I’m not advocating for the Fed to change its target in the middle of an epic battle to contain what, in the developed market context, counts as runaway inflation. Doing that would risk unanchored consumer expectations, and that would be unequivocally perilous. What I am suggesting, though, is that we don’t lose track of what we’re trying to achieve: We want a healthy economy that works for everyday people. Frankly, the long-running disinflationary regime didn’t work out all that well for Main Street. It worked great for Wall Street, though, and ditto for the rich. (I’ll have more on that in January’s monthly letter.)

For what it’s worth, core CPI is currently on track to recede to around 4% relatively soon. MoM prints below 0.3% going forward could bring a three-handle into the picture.

While acknowledging that Fed stubbornness around the terminal rate (and particularly around holding terminal for the duration of 2023) may need to be viewed more as a rhetorical insurance policy than a literal commitment, there does seem to be some genuine conviction among officials in that regard. To the extent that’s the case, it’ll seem like overkill if inflation does continue to moderate and the economy decelerates sharply, as the last ISM services print suggested it might. As one CIO told Bloomberg, “A 5% funds rate is necessary if inflation is running at 6% and 7%, not so when inflation is back down to 3%, and you could see YoY headline inflation around 3% by the middle of the year.”

The Fed (and a lot of private sector economists) like to conceptualize of inflation as akin to an infection and rate hikes as antibiotics. That’s probably a useful analogy as long as it’s not taken too literally. There’s no label on the side of the rate hike bottle that says “FINISH MEDICATION!”

Indeed, I’d suggest there’s something a bit disingenuous about the Fed’s “history shows” talking point regarding the purported perils of prematurely dialing back policy tightening. For one thing, the sample size is small, where that means n=1. If you want to break the late-70s / early-80s up, you can plausibly make that n=2, but that’s it. More importantly, though, this isn’t real science. Inflation is only a harmful bacteria in a metaphorical sense. There are all manner of inputs that explain why price growth is what it is at any given time, and many of them are behavioral, geopolitical and demographic.

The Fed acknowledges that latter point, but in what sometimes looks like cognitive dissonance, officials like to perpetuate the idea that getting the funds rate above 5% and holding it there until 2024 is the only foolproof way to kill all the bacteria. I have some potentially distressing news: The Fed could hike rates to 10%, hold them there until 2025, and inflation could still reaccelerate in the US, depending on a dizzying array of factors, some of which have nothing to do with policy of any kind. Again: This isn’t a science.

In any event, the market is now fading even the most dovish scenario implied by the most recent dot plot. “We make some assumptions on the precise cadence of the intra-year cuts given the year-end nature of the Fed’s official forecasts, but nonetheless the under pricing of future policy speaks to a market that is eager to bring forward a less restrictive policy backdrop,” BMO’s Lyngen and Jeffery wrote, describing the chart below. “It is the reconciliation of this discrepancy that we expect will represent the next operative dynamic within the rates market on the other side of terminal,” they added.

At the risk of stating the obvious: It’s highly unlikely that the hawkish outlier scenario from the dots will materialize. The idea of the Fed getting to 5.5% and staying there through Ron DeSantis’s inauguration (I’m just joking — I think) is implausible.

Of course, all of this should be paired with the boilerplate assessment. In this case, “boilerplate” isn’t meant to be derisive. There’s a base case out there, and while not everyone agrees with it (including, notably, markets), it’s the base case for a reason.

“Cooling inflation argues for step down in pace, not levels,” Goldman’s Praveen Korapaty wrote, on the way to summarizing that base case as follows:

December core CPI rose 0.3%, with the YoY rate falling another three-tenths to 5.7%. Although the reading was in line with consensus, the decline follows two consecutive months of downside misses, solidifying the perception of rapidly cooling inflation. Combined with recent weakness in activity data, it has led to markets taking down not only the expected magnitude of the hike at the upcoming Fed meeting (to 25bps) but also both peak and long-run forward rate levels. While we agree with the former, we do not believe the latter makes sense for a few reasons. First, while it is true that activity data in the US have been weak, much of this is concentrated in soft data. To the extent there is slowing in hard data, it is worth noting that the policy drag has likely already peaked and should fade over the course of the year. Second, the labor market, while admittedly lagged in showing effects of tightening, still appears to be relatively strong. Although hourly earnings data showed easing wage pressures, continued tightness in labor markets will likely make the Fed weary of financial conditions easing too soon, or by too much. Third, news outside the US (in Europe and China) points to improvements in the growth trajectory there. Combined with the possibility of accelerated net sales from Japanese investors, external developments also do not support a repricing lower of domestic yield levels.

While that argues for the Fed’s “higher for longer” narrative, it contains the ingredients for a soft landing. Recall that Goldman’s 12-month recession odds were materially lower than the average economist forecast headed into 2023.

This week, US investors will get another bit of incremental inflation data from December’s PPI report. Also on deck: Empire manufacturing, NAHB, retail sales, housing starts, the Philly Fed and existing home sales.

Fed speakers include Bostic, Brainard, Collins, Harker, Logan and Williams.