FOMC Minutes + Retail Sales + Industrial Prod. = 50BP in March

Markets are 60/40 favouring a 25bp rate hike in March vs 50bp. I was similarly positioned until January retail sales, industrial production, and the FOMC minutes were released. January retail sales more than reversed the December decline in nominal terms. In real terms, discretionary retail spending continues to lose ground marginally since the March stimulus payments. Nominal and real spending are both crabbing sideways towards rising total income, on a three-month moving average basis (Chart 1). When nominal spending meets income, spending should reaccelerate –but while waiting, consumption slows the overall pace of GDP in Q1, perhaps Q2 as well, depending on equities. A nominal decline in February spending is still possible, almost anything is for any given month, but February is too few months to change a coalescing FOMC view that consumers have taken in stride the end of fiscal transfers and less real income by essentially treading water — pulling down savings and waiting for incomes to catch up (and they are catching-up), Add in the decent expansion in manufacturing production, in January, and the FOMC is left with too high inflation, by their own admission, and no visible sharp deceleration in real activity to underpin any kind of transitory price story.

The Fed typically starts slow when removing accommodation, warms to a faster pace later, but not during this asset cycle. They waited long enough and will start with a 50bp hike. This was made clear in the January meeting minutes where they reiterated “most participants suggested that a faster pace of increases . . . than in the post-2015 period would likely be warranted.” Add to this their view that “inflation readings had continued to significantly exceed the Committee's longer-run goal and elevated inflation was persisting longer than they had anticipated” and “participants agreed that uncertainty regarding the path of inflation was elevated and that risks to inflation were weighted to the upside” and “if inflation does not move down as they expect, it would be appropriate for the Committee to remove policy accommodation at a faster pace than they currently anticipate”. It is difficult not to assume 50bp given this perspective in the face of strong hiring, accelerating wage growth, expanding production, and sustained levels of consumer spending.

As for the Fed’s balance sheet, the reduction begins in July. How fast? In their words, current economic conditions and the size of the b/s means a faster pace than 2017-19 and “a significant reduction …would be appropriate”. I wrote in mid-January to expect a $100bn/month run-off, $70bn UST/ $30bn MBS, and nothing has dissuaded me since except perhaps the UST/MBS mix (more MBS). Given how the balance sheet discussion consistently intertwined with their outlook for the funds rate in these minutes, it is very clear that running down the balance sheet is a clear expression of policy. Also, do not underestimate their desire to shrink the balance sheet rapidly to underscore to Congress that buying UST is an instrument of monetary not fiscal policy. As for the details, notably the possibility of asset sales, “no decisions regarding specific details for reducing the size of the balance sheet were made at this meeting” but that they aim “to retain the flexibility to adjust any of the details of its approach in light of changing economic and financial conditions”.

Asset sales are consequently still a strong possibility come July, but it depends, and this can be said about the whole direction of policy looking past March. There is a clear pent-up desire to move on inflation now, especially with growth momentum still strong. Yet, there is also expressed uncertainty as to where the economy ends up so many months down the round. For this reason, the Fed appears quite content to make policy a meeting-by-meeting decision. Essentially allowing communications to sculpt markets as a first move (job done!) and then deciding at each meeting whether data give them reason to act. Put another way , if one believes the pace of growth and inflation unwind far enough as the year moves on, the back-end pace of implied rate hikes is too steep. This is a back-to-front policy trajectory. The Fed allows itself to quickly do what needs to be done now, believing resilience among households and business gives them leeway to be aggressive, and then leave for themselves a wide range possibilities for what to do later, including nothing at all. It is well within the realm of possibility for the Fed to raise rates 5obp in March, maybe hike rates 25bp at the May and June meetings, and then do nothing for the rest of the year. We are as far from the 25bp hike/meeting world of recent cycles as can be imagined.

What about the equity market? Understanding this is an asset cycle rather than a credit cycle is a critical distinction. There is no surge in lending to get ahead of by raising rates. The thrust of growth in this cycle, after reopening, comes from equity — a government infusion of equity capital into household and business balance sheets (stimulus payments and PPP) and the equity market’s rapid advance. Complicit in their forceful impact was the Fed driving real yields well below zero, across the curve — yes the balance sheet matters. Going in reverse means equities are the lever through which the Fed slows growth – and this means running down the balance sheet. If inflation remains stubbornly high, the Fed will be confronted with having to weaken equities further to pull down growth – hence the potential for asset sales in the summer.

In sum, the Fed will jump out and tighten 50bp in March — confronted as they are with stubbornly high price inflation, expanding activity, and an accelerating wage cycle (three-month moving average of median wage growth for prime age workers jumped to 5.5%, annualized, in January, according to the Atlanta Fed). The Fed figures households and business are resilient enough to handle the hike, but they won’t be forever and that is the point to keep in mind. There is no benign removal of this monetary accommodation, growth must be slowed, yet to a limit because there is no mandate to create a recession. In this asset cycle of the Fed’s creation, the economy slows by pressuring the equity market through higher term yields – created by lifting the trajectory of the funds rate and reducing the balance sheet. There are, however, myriad reasons (domestic and global) to expect demand and inflation to unwind on their own accord in the coming months. Because this possibility is realistic, but no one knows the extent to which the slowdown reaches, the Fed is left with no set trajectory after March, every meeting has the potential for the Fed to do something (25 in May and 25 in June?), asset sales in July, or nothing at all — It all depends. This is far from the monetary policy regimes of recent or distant memory, when tightening meant a slow, steady predictable march to some prospective target rate, but here we are. My own view is that after this transition from Covid-reopening boom to the “long cycle”, growth and inflation will track higher than during the prior expansion and the Fed, unwilling to kill growth to drive inflation back to 2%, will call it a day once inflation is tracking 2.5%-3.0%.