50 is the new 25
Hard to think of anyone who personifies the title of this blog better. The hawkish pivot of the Fed which began last December is still playing out. When the idea of 50bp hike was first floated by Bullard, it delivered quite a shock to the front-end rates market which until then was expecting a path of steady 25bp hike per meeting with even a couple of on-hold meetings along the way. The initial commentary out of the centrist and dovish members of the Fed was that 25bp to start the cycle and 50bp later in the year might be appropriate should inflation not moderate towards their forecast. But the strength of the labor market and continued pressures on inflation with risks to upside exacerbated by Ukraine crisis and China Covid lock-down, the committee has coalesced around hiking by 50bp at the next couple of meetings. The next three meetings are assigning higher probability of 50bp (with first 2 almost fully priced). This is hardly a surprise given how far behind the curve the Fed is, that once they opened the door to 50bp increments the market priced this path quickly.
Reviewing a few central banking ideas that are well-understood but worth repeating nonetheless to frame the discussion -
Central banks are creatures of inertia because the market impact of the signal associated with the shift in policy is much larger than continuing along the path of existing policy. Put another way, the hurdle to the first hike or ease when the central bank is on-hold is much higher than the hurdle for subsequent hikes / eases and conversely, the hurdle to stop hiking / easing is higher than to continue once they are on the path.
The intent of the Fed is to tighten financial conditions to slow the economy - the channels of which are short-term and long-term rates, credit spreads / equity prices and US dollar.
The tightening of financial conditions needs to be sustained for a long enough period to impact the economy - sharp moves that are reversed quickly don't have much of a lasting impact on the real economy.
The feedback to the economy operates with long and variable lags and the impact of policy tightening could take 12 - 18 months to be reflected in the economic activity and inflation data.
Probably the best but a noisy and not necessarily most accurate real-time indicator of policy impact is financial conditions. Financial conditions are influenced by variables other than just Fed policy and they don't always move in a well-behaved manner - large shifts are not uncommon.
The Fed isn't going to get clear signal from the economic data for at least the next couple of quarters that reflects the impact of its policy tightening. The labor market in particular tends to be inertial i.e. a slowdown in pace of hiring is likely but unemployment rate probably continues its march lower. Inflation base effects are favorable no doubt and goods inflation showing some signs of slowing but the slower moving services inflation much like labor market tends to be inertial and likely to stay comfortably above Fed's 2% target in the months ahead.
This puts the Fed in a tricky position. Once the Fed hikes 50bp for a couple of meetings, a step down to 25bp hikes will be perceived as a dovish signal and likely result in an easing of financial conditions which is counter-productive to its goal of slowing demand. The most likely variable that could lead to a step down in pace of hiking is a disorderly large tightening of financial conditions - but that's a two-edged sword. On one hand, it means policy tightening is starting to bite and slowing of pace of tightening is justified but on the other hand if the labor market and inflation data don't confirm policy shift, the Fed risks undoing the tightening and failing to slow demand sufficiently to bring inflation down. The credibility cost of exercising the 'Fed put' has never been higher.
In conclusion, once the Fed hikes 50bp at the next meeting that will become the default increment until a large shift in labor market and/or inflation data (more likely 3 to 4 quarters from now than next quarter) or a disorderly tightening of final conditions that is large enough that even with a partial reversal on the Fed slowing down the hiking pace will still be tight enough to slow the economy. Lastly, the market has internalized 50bp increments and Fed has more-or-less maxed out on QT. This means if the Fed needs to turn more hawkish to slow the economy it will need to use 75bp hikes (with Bullard quickly reserving a CNBC spot to announce his 100bp hike recommendation). The path of least resistance seems a Fed that continues to out-deliver the hikes priced by the market till financial asset prices decline meaningfully lower.