Confidence in the Fed will decline further: Macro Hive’s FOMC preview

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The fact that the Fed sticks to its current policy plans at next week’s meeting should compound the market’s loss of confidence and therefore see the curve steepen further.

  • The Fed already pre-announced the start of quantitative tightening and a 50 basis point rate hike at Wednesday’s FOMC meeting as part of its plan to tackle high inflation.
  • The real uncertainty is whether the Fed is raising its expectations for the level of the federal funds rate and the neutral interest rate.
  • That seems unlikely, which could heighten market concerns about the Fed’s ability or willingness to fight inflation.
  • Loss of market confidence in the Fed’s inflation-fighting mojo could steepen the yield curve.

Quantitative tightening

As usual, the Fed hinted at its policy changes ahead of Wednesday’s FOMC meeting. Based on the March minutes, a quantitative tightening (QT) should begin.

This is where the Fed is trying to reduce its holdings of securities.

QT will probably do the following:

  • Monthly reinvestment caps would be $60 billion for treasury bills, $35 billion for mortgage-backed securities (MBS).
  • The cap would be staggered over three months “or slightly longer if market conditions warrant”.
  • When Treasury principal repayments fall below the $60 billion cap, the difference with the cap must be made up by not reinvesting the TBills.
  • Because MBS repurchases are expected to remain well below the cap, and because in the long run the Fed only wants to hold Treasuries, the Fed intends to proceed with outright sales of
  • MBS “after balance sheet runoff is well underway”.
  • The meeting is likely to work out the details, including the transition period, which could be, for example, $30 billion in May, $60 billion in June and $95 billion thereafter.

Upgrade to a 50 base point hike

Additionally, ahead of the pre-meeting blackout, Chairman Jerome Powell on Wednesday voiced support for a 50 basis point hike. The market has already priced this in. I find the risk of 25 or 75 basis points low:

With inflation at 8.5%, if the Fed delivers less than the market expects, it will lose even more credibility. Moreover, as financial conditions have tightened, the Fed finds the labor market very tight and expects above-potential GDP growth this year: with high inflation, the Fed’s put has effectively disappeared .

Meanwhile, FOMC members have pushed back the 75bps, perhaps because their current understanding of inflation implies it’s not necessary.

Additionally, markets are now pricing in a 50% chance of a 75 basis point hike at the next FOMC meeting in June, and press participants will be sure to ask about it.

I don’t expect Powell to support 75bps so early in the cycle, largely because that would be an implied admission of policy error.

How high could the Fed’s interest rate go?

The most interesting news to come out of the meeting is whether the Fed changed its estimates of the neutral rate, 2.4%, and the terminal rate, 2.8% (the expected high point for the federal funds rate ( FFR)).

FOMC chatter ahead of the meeting implied that the FFR would be down to neutral by the end of 2022.

The Fed effectively revised its end-2022 target up to 2.4%, from 1.9% at the March meeting and 0.9% at the December meeting.

Following Friday’s publication of an editorial in The Economist highly critical of the Fed – and predicting a terminal FFR of 5-6% – Powell is likely to face a steep pullback during the press.

I expect Powell to respond with his usual “we will adjust policy as necessary to ensure a return to price stability with a strong labor market” rather than signaling a material change in the neutral or terminal rate.

Indeed, the current estimates reflect the strong convictions of the Fed in its inflation models, namely the Phillips curve augmented by expectations and a low neutral rate (Terminal Fed Funds to Approach 8%).

The Fed’s inflation model implies that, as long as inflation expectations are anchored, inflation should be self-correcting. The data falsified this: inflation jumped against flat inflation expectations.

Still, stronger evidence will likely be needed for the Fed to raise its terminal rate expectations near my 8% forecast, e.g. FFR above 3% and core inflation stable above 4%. These might not be available until late 2022.

Instead, I expect the Fed to follow the market which is currently forecasting 50 basis point hikes in May, June and July. As inflation remains elevated, I expect the market to gradually price 50 basis point hikes in the remaining policy meetings and the Fed to follow the market.

Market consequences

The yield curve has steepened recently. I think this reflects a loss of confidence in the Fed’s ability to control inflation based on its current policy framework (see chart 2).

The loss of market confidence is illustrated by the fact that BE 5y5y have broken the 1.5-2.3% range of the last five years, even though expectations regarding the long-term policy rate, for example the swap at term OIS 2y1m, rose to post-GFC highs (see chart 3).

Basically, the market is less and less convinced that a terminal rate of 2.8% can curb inflation, which is currently close to 8.5%.

The fact that the Fed sticks to its current policy plans at next week’s meeting should compound the market’s loss of confidence and therefore see the curve steepen further.

This article is syndicated to Pound Sterling Live by Macro Hifri.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DM in hedge funds, sell side, New York Fed, IMF and World Bank. She publishes the Macro Sis blog which discusses macro yield factors.

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