FOMC Preview: It Is Volcker Until Neutral

Summary

• The Fed will almost certainly raise rates by 50bps and begin quantitative tightening on Wednesday.
• The Fed has one focus: inflation. This week’s meeting will reinforce the committee’s commitment to ‘restoring price stability.’
• Within that framework, everything is on the table, including a 75bp hike in June.
• The strength of the labour market will prevent the pace of hiking dropping to 25bps before hitting the neutral rate. At a minimum, I expect 50bps until neutral.

Can the Fed Surprise?

There are few things the market is unaware of entering the May FOMC meeting. It knows the Fed will raise rates by 50bps. It knows the Fed will announce the beginning of quantitative tightening (QT). And it knows the next move is not back to the Fed’s usual 25bp pace and that the ‘expeditious’ return to neutral infers a faster pace than traditional cycles.

With that, the market is taking very seriously a 75bp increase in June and the Fed returning to their median estimate of neutral at either September or November. The question entering the FOMC meeting, and especially Chair Jerome Powell’s press conference, is this: is there room for the Fed to really surprise hawkish given the extent of the pricing? June is more likely to be 75bps, and the market is priced for almost a 3% funds rate by year end.

The Hawkish Trade Is Still On

To me, the hawkish trade is not over. And here is why:

1. There has been a constant bias into FOMC meetings to say, ‘there is a lot priced’. Yet Powell has added incremental hawkishness at every Fed meeting this year. That likely will not change this week, with 75bps on the table for June’s FOMC meeting.
2. The ECI reading on Friday reminded the Fed that while the peak of inflation is in, it still may be at a troubling trend rate that a very tight labour market could exacerbate. This will be a further worry if we see continued employment gains that see the Fed ultimately lowering its U3 forecast at their June or September SEP meetings.
3. There are three stages to this tightening cycle, and we are firmly in the first one still. The Fed wants get to neutral as fast as possible, and, until they get there, everything is on the table.

Fade ‘Fully Priced’

There is something innate to hiking 50bps: it is an admission and a message that the Fed are playing catchup. The Fed will not want a 50bp hike to be digested as anything other than a hawkish message of intent. This is something I think the market has consistently missed in this hiking cycle so far – the Fed is incrementally hawkish because they are not at the point they desire. They want to be at neutral right now, they are not there, and they will do whatever they can to get there as fast as possible.

As Fed Governor Christopher Waller said, ‘We want to get above neutral certainly by the latter half of this year, and we need to get closer to neutral as soon as possible.’

The pricing is aggressive, but the Fed will not stop being aggressive until they are at their desired policy stance. That is now a neutral policy setting with upward optionality. There is no Fed put as long as the Fed is below neutral, and there is nothing hawkish off the table until they get there.

Brainard’s Speech Was Revealing

I think something that is becoming clearer is that the goods side has peaked. And while we do not know to what level, inflation has peaked too. The question now is: even if the ‘destination’ (trend rate) is not clear but the ‘path’ (decelerating) is, will the Fed sound and deliver as hawkish as they have been recently?

This is really the key question to me now, especially with the next three meetings priced and the focus shifting to whether autumn FOMC meetings see the dropdown back to 25bps.

This question I think became especially interesting after listening to Vice Chair Lael Brainard three weeks ago. In two weeks, Brainard spoke twice. One was in prepared remarks, and one was in a more fire-side chat-type setting with WSJ reporter Nick Timiraos.

In the prepared speech, she was quoting former Chair Paul Volcker. In the more casual chat, she was essentially echoing the transitory message, saying inflation was mostly just a ‘series of shocks.’ It was telling in terms of what Brainard is probably personally thinking, and I think really increased the importance of the question: will the Fed cave once the ‘path’ (inflation deceleration) is confirmed even if destination (trend level) is not?

My short answer is ‘no’.And I think an underdiscussed reason for an elevated hiking pace is the labour market.

The Employment Side Will Enter Focus as Inflation Peaks

The labour market in the US is very strong. The pace of hiring is high, the market is tight by any measure, the level of unemployed is low, and aggregate wage growth is high.

Of course, we could get participation back. But at core levels such as prime-age EPOP, the labour market is already back to/above pre-pandemic tights. Powell has consistently mentioned job openings relative to unemployed and the KC Fed labour market index – both of which are at all-time highs. Then, of course, there was the tone change from Powell at the March FOMC meeting when he said the labour market was already tight to an ‘unhealthy’ level.

The thing I am most worried about for the Fed right now is a dynamic where core PCE will be making its move to a three handle when U3 is making its move to a two handle… no off-ramp.

I think by the September FOMC meeting, the Fed will have to lower its U3 forecast for 2022 and maybe by a lot. And the question is, if the Fed is lowering its U3 forecast, which is already below NAIRU, from 3.5 to 3.2 at well above target inflation, what is the reaction function? The problem for the Fed is that the focus by the second half of the year will shift from the 2022 core PCE dot to the 2023 one. And in a world where the labour market is even stronger than they thought, mathematically they will have to raise their 2023 inflation forecast. 2.7 2023 PCE must be moved higher if 2022 U3 is moved lower. That is a problem.

To me, to get a drop off back to 25bp hikes before neutral, you need to see slowing in the labour market, and we may see the opposite. The economy is strong right now.

Despite inflation peaking, the drop off to 25bp hikes does not happen this year. The labour market just will not allow it. And at a minimum, it is 50bps until neutral. The strength of the labour market will challenge confidence in the deceleration, especially at levels below NAIRU.

The other important factor in this context is the signal effect of returning to 25bp hikes. This is a very EM concept, but in EM hiking cycles, once the pace slows, the market prices the end. This is something we saw this year in Brazil when Copom dropped the pace from 150bps to 100bps. Now, that ended up being a false start in terms of pricing the end, but I think it is something the Fed will be very mindful of. Now that 50bps is the pace, you need a catalysing reason (neutral, markets, economy) to drop back down.And for now, they lack one – the economy is too strong.

Fed ‘Stages’ Framework

As the Fed enters this escalation period of policy tightening, I think it is a good time to step back and look at this cycle could evolve. I think about it in three stages that will correspond to different reaction functions from prior Fed chairs.

Step 1: They are Volcker until neutral. They will get there this year. The market will hold the term premium because at this level of U3 (below NAIRU), nothing can stop them.

Step 2: They get to neutral and its Greenspan time. This is where ‘humble and nimble’ comes into play. The Fed is happy that inflation is decelerating but is still slightly worried that the 2024 core PCE forecast is still slightly high at 2.3%. In other words, the Fed is in no rush to get to 2%, but they want to see it confirmed by the end of the forecast horizon being at target, especially as that rate is effectively just inflation expectations.

Step 3: They are Yellen at 3.5%. Once the fund rate gets to 3.5% and they are now above pretty much anyone’s estimate of neutral, this Fed will be mindful of breaking things in a hard way. That to me was the takeaway from Brainard this week. The Yellen tenure at the FOMC was all about getting reasons not to go. I think that is what the Fed’s reaction function will look like once the funds rate has a three handle.

The Bottom Line

I think there are three stages of this cycle, and we are currently firmly in stage one. In the Volcker stage, nothing can put them off their path, there is no Fed put, and inflation is the only concern. Once policy gets back onside, the Fed will become a lot nimbler, and more Greenspan like. After that, the Fed is intent on landing this thing softly and as long as inflation returns to 2% at the end of their forecast horizon, their reaction function will look a lot different than it does now.

But that is then, and this is now. The Fed has one focus: inflation. And this week’s meeting will reinforce the committee’s commitment to ‘restoring price stability.’ And within that framework, everything is on the table, including a 75bp hike in June.