Heisenberg Macro The Fed reaction function can be visualized by mapping the 3 variables - unemployment rate, core inflation and policy rate relative to their neutral levels on a Tic Tac Toe Grid. Though I have characterized the unemployment rate as neutral, it can certainly be argued that at least on a short term basis it is below neutral. Taking inventory of where we are now -
Great article.. I think if you get the Triple 3, it'll be a homerun scenario for Fed and economy. 3% nominal rate with 3% core inflation is still lower bound of 'real' neutral rate of 0%. Also, a 3% core inflation rate is in the vicinity of 'opportunistic disinflation' territory. if that scenario materializes, i think Fed will continue to run down the balance sheet and perhaps hike to 3.5% (i.e. 2x25bps ) in a leisurely fashion and stop. Equities may not have any real issues except for margins, but that's a wholly endogenous issue for corporations.
However, getting 3% UE rate with 3% core is probably an unstable equilibrium, given current starting points. Even if that situation comes to fruition as a likely juxtaposition of deflating core goods vs services inflation, it may most likely be temporary. More likely is that wage pressures will be sufficiently large and persistent at 3% UE to keep pushing inflation higher again. in which case, they may have to keep hiking till UE rate is NAIRU bound or higher.
In any case, the Fed cannot respond to any downside risks till they get inflation to sub 2.5% or so. And it seems there is no path for inflation to come to reasonable territory without UE rate going up. It would be a miracle if risk assets escape a trip to the left tail!
Great article.. I think if you get the Triple 3, it'll be a homerun scenario for Fed and economy. 3% nominal rate with 3% core inflation is still lower bound of 'real' neutral rate of 0%. Also, a 3% core inflation rate is in the vicinity of 'opportunistic disinflation' territory. if that scenario materializes, i think Fed will continue to run down the balance sheet and perhaps hike to 3.5% (i.e. 2x25bps ) in a leisurely fashion and stop. Equities may not have any real issues except for margins, but that's a wholly endogenous issue for corporations.
However, getting 3% UE rate with 3% core is probably an unstable equilibrium, given current starting points. Even if that situation comes to fruition as a likely juxtaposition of deflating core goods vs services inflation, it may most likely be temporary. More likely is that wage pressures will be sufficiently large and persistent at 3% UE to keep pushing inflation higher again. in which case, they may have to keep hiking till UE rate is NAIRU bound or higher.
In any case, the Fed cannot respond to any downside risks till they get inflation to sub 2.5% or so. And it seems there is no path for inflation to come to reasonable territory without UE rate going up. It would be a miracle if risk assets escape a trip to the left tail!
Crafty! Love it