AIT was the promise that the Fed would chase inflation rather than be pre-emptive and here we are, promise kept. Powell now promises the chase to be executed, using a combination of rate hikes and balance sheet liquidation, in a predictable manner in what is, by all accounts, a very unpredictable world. In other words, impossible.
The statement and associated releases were dovish in tone because they conveyed no concrete determination for the pace of removing monetary accommodation – thereby alleviating some of the hawkish trajectory for rates and balance sheet shrinkage the market had priced in.
Powell undid what the statement and balance sheet principles did for market sentiment by expressing his conviction about the direction of growth (above trend) and inflation (remaining too high). He acknowledged two-sided risk to the outlook, but his sides lined up with Covid over there and much higher inflation over here. The supply chain relief he is waiting for looks to be a 2023 event, by his account. He also did not exactly rule out a 50bp hike in March, although I still think it is unlikely.
There is no such thing as a dovish tilt to tightening, tightening works because it slows economic growth first. Problem is, in the current instance, it is difficult for the Fed to slow growth because growth is not rooted in private credit expansion. It is rooted in fiscal transfers and over-extended asset prices, all aided and abetted by too low interest rates for too long – long the bane of Fed policy.
The only credit expansion to curtail is the Federal Government’s and the Fed’s balance sheet. The sharp narrowing of the deficit this year (less fiscal impulse is econ-speak) appears to be the main reason why the Fed expects growth to slow this year – they see Omicron’s impact on Q1 as passing. Uh-oh. If their underplaying Q1 weakness does not raise your concern that something more critical might be afoot in the economy, then you probably haven’t been tuned into Fed forecasts for very long.
The Fed’s options to slow growth are through the dollar or weakening equity markets or both. To this end, Powell relayed the FOMC’s view that their degrees of freedom to act are great – the labor market is historically tight and household/corporate/bank balance sheets are very strong. From the Fed’s perspective, labor markets and balance sheets are not, today, particularly vulnerable to higher interest rates or lower asset prices. Powell reiterated many times that this is not 2015 – inflation is too high, growth is substantially above trend, and labor markets are historically tight (although the unemployment rate remains soft, a dovish hint). Powell lowered the strike on the Fed put.
Powell admitted that the Fed has no rule other than to react to what’s in front them –what happens when policy chases rather than preempts. The Fed will consequently drive interest rates to where they think they belong today, by using communication, market-makers need not apply.
As for the terminal rate for Fed funds, it will be one or two tightenings too far – why should this cycle be any different? The end comes when the funds rate is at least equal to inflation if not slightly above. If inflation stays elevated through this cycle, 2.5%-3.0% has been my forecast, then this is where the terminal rate will be.
How fast will they get there? My guess is longer than Powell seemed to indicate today. I do not believe the Fed is really so insensitive to rates or the equity market and their knock-on effects – especially as growth slows. By admitting the unemployment rate is still soft, just how far is the Fed really committed to stamp out inflation everywhere. Powell also made mention of wanting the balance sheet reduction to be predictable and behind-the-scenes. We add to this his wanting to keep the funds rate front and center as the indicator of policy, and his noting that no one has any predictable tie between the balance sheet and interest rates (I agree). This is a dovish hint to policy as well.
In the end, Powell's press conference was the FOMC's answer to the monetarist critics – they know they are late, and in response they give word that they are going to plow ahead and do what’s necessary with plenty of runway to act aggressively. But not for another six weeks on rates and another 18 weeks before they start shrinking the balance sheet.
I see an economy transitioning from Covid-boom to the long cycle that Powell referred to. During this transition, the worry-about-today Fed will face some weaker numbers soon enough that takes some starch out of the growth/inflation conviction Powell expressed. As such, hike in March, balance reduction begins in July, but I am not yet ready to buy umpteen hikes in short order. As for where the Fed put now sits, Powell today effectively dared the market to find out. It would not surprise me if they did.