Measured Pace 2 - 'Expeditiously'
The iconic race scene from Fast and Furious characterizes how the market is perceives the the Fed meeting today with some convinced Powell is about to turn up the nitrous oxide of 75bp hikes to win this race against inflation. In reality, the race against inflation is more like winning 24 Hours of Le Mans race than this and not sure the NOS tank would be of much use in that one.
For all of this year, the Fed has continually ratcheted up its hawkish rhetoric and policy path to catch up to the strength of labor market and the breadth and persistence of high inflation. The market seems to be squarely focused on assessing whether we are at 'peak hawkishness'. The way the term 'peak hawkishness' is used doesn't make a whole lot of sense to me. In my view, hawkishness / dovishness technically refers to policy stance versus the appropriate policy needed given the state of the economy relative to the central bank mandate. In that context, the Fed arguably was way more hawkish in 2017 when it was hiking 25bp-a-quarter with inflation below target relative to today where even 50bp-a-meeting might not be sufficient given how far inflation is above target. Put simply, the Fed is not veering off its warpath on fighting inflation until it is clearly within striking distance of victory.
But what I think are fair questions is whether we are at 'peak terminal rate pricing' or 'peak policy uncertainty'. On the former, I argued why I don't think so in my previous note. On the latter, I do think we are approaching that point unless long term expectations in the coming months show clear signs of unanchoring complicating the Fed task even further. In my opinion, the uncertainty around the policy path on a forward looking basis is lower for the following reasons -
With the Fed starting so far behind the curve, it had to play catch up in a short span of time which widened the distribution of possible near term policy outcomes increasing uncertainty i.e. volatility. But with a likely 50bp hike and a ramp up to 95 billion/month QT today and a reasonable amount of hikes priced into the curve, the Fed has regained considerable inflation fighting credibility reducing the need to further widen the distribution from current levels.
With the committee squarely focused on getting to neutral expeditiously, the odds of not hiking at a meeting or a premature pause of hiking cycle below neutral is fairly low. With each successive hike, the distribution of policy rates below neutral is truncated limiting the distribution of possible outcomes.
With the announcement of QT today, any remaining uncertainty around the specifics of the program will be addressed. There is a lingering risk of MBS sales, but I think its quite unlikely to be deployed in 2022 particularly since mortgage rates have risen considerably already.
More importantly, I strongly believe that 50bp is now the default pace until the labor market weakens meaningfully and core inflation shows signs of moving sustainably lower towards the Fed's 2% target. For those who remember the 2005 Greenspan 25bp-a-meeting tightening cycle, 'expeditiously' is the 'measured pace x 2'.
The immediate push-back to this narrative is 75bp has been floated as a possibility by both Bullard and Daly who are at opposite ends of the hawk-dove spectrum. In my opinion, the hurdle for stepping the pace up to 75bp is quite high (and low probability over most of 2022 at least) for the following reasons -
Fed acknowledges that it has to hike rates above neutral - possibly significantly above - and sustain them at high levels for a period (given the lags in policy) to credibly counter the threat of high inflation. Fed's goal is to maximize the degree of and period over which they can maintain restrictive policy to slow inflation to target and anchor long term inflation expectations. Minimizing risks of disruptions in markets arising from policy uncertainty is consistent with achieving this goal.
The Fed wants to unequivocally tighten financial conditions to slow demand and the FCI tightening this year confirms that channels of policy transmission are working as desired. But given recent market fragility, risks are rising of a rapid abrupt and disorderly tightening that could threaten to knock them off their hiking path. Upping the ante to 75bp amplifies that risk without arguably much incremental benefit.
Despite inflation risks clearly dominating, the Fed still has a dual mandate and would like to engineer a soft-landing where the trade-off needed in unemployment rate is just enough to bring inflation back to target. Treating the appropriate pace as a decision to be made on a meeting-by-meeting basis (and spot data dependent) with all options (25,50,75,100) open puts it on a persistently volatile path that makes achieving soft-landing much less likely.
Bottom line, the Fed is not about to step down from its single-minded focus on tightening policy to curb inflation pressures and a dovish outcome is not even in the probability distribution of outcomes. But there is a difference between a gun-slinging approach and a methodical deliberate plan to achieving its mandate. I think that's where we are headed beginning today and we might need to get past the June meeting (with the updated SEP and dot plot) to solidify the transition from a chaotic hawkish pivot to a aggressive but structured hiking plan which will be in place till inflation overheating risks recede meaningfully. From a markets perspective, given starting levels the reduction of uncertainty should provide a short-term relief in risk assets and implied volatility in rates and equities - but it makes higher terminal rates more likely not less and path for FCI is still points towards more sustained and prolonged tightening.