There is a concept within the community of “Fed-watchers” of a “live meeting” where there is a significant chance of the Fed actually changing policy.
This week’s FOMC gathering will most certainly be a “live meeting.”
The Fed has pivoted significantly over the course of the last few months from being concerned about choking off a recovery to being focused on ever-growing, and seemingly persistent, inflation pressures. Ever-increasing prices of goods and services that have expanded far behind more volatile energy and food levels are not an indicator that the Fed has work to do, but that they have made a significant policy error with notable economic and political consequences.
As such, we believe that the Fed will take two actions in the March meeting: They will raise its Federal Funds rate target off the zero bound to 25 basis points (bps), and they will finally end the regular purchases of bonds. Yes, throughout this inflationary environment the Fed has been pumping the money supply. We believe that conclusively ends this week. Notably, they have increasingly indicated that they are data dependent, and as such any move they make in the upcoming meeting may or not be followed by subsequent actions: They don’t have to make that decision now.
Further immediate inputs to the decision on March 16th include:
- The February employment numbers, which continued the strength seen as the Omicron variant infection wave dissipated
- February’s set of inflation figures as the year over year CPI accelerated to 7.9% from January’s already 40-year high of 7.5%, and
- The ECB’s decision to end its bond-buying program in the third quarter as inflation accelerates in the eurozone
Moreover, real average hourly earnings show that while wages are increasing at levels not seen in decades, they are not keeping pace with price increases, leaving the Fed in the position of being blamed for the average person’s decline in purchasing power.
Therefore, we expect that over the year they will likely raise rates by 25 bps four to five times, with a potential significant change in their balance sheet holdings. We believe that change will come largely from the sale of mortgage backed securities assets over time.
How did we get here?
The Fed decided to adopt a framework that was well suited to the economic environment that the US found itself in for the decade post the Great Financial Crisis; inflation was quiescent, despite low unemployment. The relationship between the two, the so-called “Phillips Curve,” was deemed to be flat, meaning that lower unemployment did not seem to cause increased price pressure. Whether financial instability was the result of very low rates (as was the case in the mid-2000s) was not considered relevant by the Fed. In fact, they adopted “financial conditions” measures that included equities and pointed to rising risk asset prices, low inflation, and low unemployment as indicative of the success of their policy. Indeed, there was very little cost in keeping rates low, in their view.
Post the Covid disruptions, and the “heroic” measures that the Fed took to keep markets operating, the Fed adopted a framework of average inflation targeting (AIT), that argued for lower rates for longer in order to make up for prior periods where inflation had undershot their target. As a result, they deliberately set themselves up to be “behind the curve.” When significant amounts of stimulus were added to the economy, and the invention of effective vaccines along with other medical and social changes caused the economy to re-open, the Fed continued to press forward with accommodative policy as that recovery gained momentum. This, again, was deliberate. The trouble came when the speed and strength of the economic and price recovery overwhelmed the speed at which the Fed was willing or able to act to depress price pressures.
At this point, it’s unlikely that inflation will be transitory if the definition is measured in months. Shelter costs and wages are rising significantly, and even with a solution to supply chain disruptions it’s unlikely that we will return to a more normal rate (say below 3%) before at least the end of 2022. This is one reason why the “Whip Inflation Now” rhetoric of the Biden administration is increasing dramatically in the run-up to mid-term elections in 2022. Adding in the conflict in the Ukraine, which will only serve to increase headline inflation (primarily through higher commodity costs, but also through additional supply chain challenges), will not cause the Fed to pause its tightening cycle, at least in the near term.
The Fed has placed itself behind the curve and they will have to catch up over time. Indeed, with an AIT framework the Fed “should” be working to drive inflation below 2%. Furthermore, a flat Philips curve means that much higher rates and unemployment will be necessary to tame inflation. All the challenges that the Fed had are still in play, but in reverse.
Notably, the risk of a recession in the US has increased over the next 12 months. The Fed has run an experiment whereby they attempted to avoid recession (notably at the end of 2018) or any downturn by keeping rates low. The Covid downturn was an exogenous shock, but simply extended the credit cycle. It is worth remembering the period in the mid-2000s when the Fed raised rates consistently by 25bps (using the descriptor “measured,” which has re-entered its lexicon) from 1% to 5.25% after a period in which the Fed had not raised rates for years. Despite moving notably (again, after a too-long period of low rates), the world still endured a recession largely due to overleverage, particularly in the consumer sector. We believe that the Fed will move, and that those movements will look very similar to the cycle of the mid-2000s than the cycle of the mid-2010s (which is to say, consistent and persistent).
The big takeaway is that the period in which low rates was a tailwind for risk assets is ending, and there are notable consequences to that which will be felt over the coming months and years. Volatility is rising, and the outlook is “unusually uncertain.”
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