As First Rate Hike Lands, Know the Fed Is Dead Serious About Prices

The Federal Reserve hiked its interest rate target by a quarter percentage point. This comes almost exactly two years after the Fed cut its target rate to zero, hoping to avert a severe recession. Now, the Fed faces an even tougher task: With the economy booming and inflation at multi-decade highs, the Fed will try to slow inflation without overly damaging growth. Engineering a soft landing such as this has often been tried, but rarely been achieved. Here are some thoughts about what the Fed said today and how policy may evolve in the coming months. The Fed Intends to Hike Aggressively Since a quarter-point hike was widely expected, this Federal Open Market Committee meeting was really about future guidance. How aggressively will the Fed hike, and what might cause it to accelerate or decelerate that pace? Our first clue comes from the Summary of Economic Projections, which includes the closely-followed dot plot. In December, the median dot for year-end 2022 suggested three 25-basis point hikes. Now the median is at seven. That was widely expected, and the market had priced in seven hikes already ahead of this meeting, but it is still notable how quickly the Fed has ramped up its hawkishness. It is also interesting that there is a lot of divergence. Of the 16 FOMC members, seven put their dot at eight hikes or more. So at least in terms of the committee's mentality, they are leaning toward doing more, not less. Fed Chair Jerome Powell seemed to endorse a hike at every meeting. At times in the past he overtly distanced himself from the dots, but in this case he seemed to endorse them. For Treasury Yields, 2023 Is What Matters It is notable that the Fed's 2023 dots are far above what the market had priced in ahead of this meeting. While Fed funds futures markets have priced in 175bps of hikes for 2022, prior to this meeting there was only one hike priced in for 2023, and then one rate cut in 2024. The Fed's 2023 median dot implied an additional three or four hikes in 2023 and then holding steady in 2024. After the meeting markets added one hike to those expectations for 2023, and still has a rate cut priced in for 2024 and maybe a second one in 2025. How this ultimately plays out is critical to where Treasury rates evolve in the coming months. There is lots of room for 2023 and 2024 Fed hike expectations to build, and that would force three to five year yields higher. Indeed, after this meeting, that part of the curve surged higher, jumping 12bps to 14bps immediately after the FOMC release. Let's get back to the fact that a 2024 rate cut is priced into futures markets. It is important for readers to internalize what this is telling us. Bond traders think that if the Fed hikes to around 2.25%, the economy will weaken substantially. By then projecting a subsequent cut, the market is saying that slower growth causes inflation to subside and the Fed becomes refocused on slowing growth. Quantitative Tightening Coming I thought we might get a clearer signal about Quantitative Tightening (or the process of shrinking the balance sheet). All Powell said was that QT was discussed and the process will begin at an upcoming meeting. Later he indicated that the plan was pretty well formed, and could be implemented at their next meeting in May. He also said that QT would look familiar but go faster than the 2017-2019 QT period. That isn't news, as he has indicated the same in previous communications. Regardless, looks like QT is coming in May. There might be some additional detail when the minutes of this meeting comes out. Yield Curve Inverts In the immediate aftermath of the meeting, the Treasury yield curve inverted at certain points. The five-year and seven-year Treasuries traded just slightly above the 10-year, and the gap between the two and 10-year narrowed to only 23 bps. Classically, an inverted yield curve is a bad sign, as it tends to indicate that an expansion is coming to an end. Usually this has been because a Fed rate hiking cycle is coming to an end and markets start anticipating the next move will be a cut. That obviously isn't the case right now, since the hiking cycle just began. Rather, this near-inversion comes from the same narrative I mentioned above, that markets think there is very limited room for the Fed to hike before curtailing growth. The dots tell us the Fed doesn't agree. The Fed thinks it has much more room to hike, maybe all the way to 3%. The market doesn't buy that. If it turns out the Fed is right, the curve probably remains extremely flat, but yields keeps rising. If the market is right, then the current yield curve is fair value. This is why I still think the risks to yields are skewed to the upside. Credit Markets Laser Focused on the Fed Corporate bonds have sold off more than Treasuries so far in 2022. Obviously uncertainty around the Ukraine invasion hasn't helped, but I don't think that's what is driving credit markets. Over the last three weeks, we've seen a few sudden lurches higher in stocks, usually on some rumor of ceasefire talks or the like. However on such days, credit markets generally remained weak. I believe this is because credit is more focused on the Fed than Ukraine. This fits with the narrative mentioned previously that the Fed can't hike that much before impairing growth: Both the credit market and rates market are telling you that a recession is becoming a bigger risk. As I've written before, I'm generally optimistic about U.S. growth. I think a tight labor market results in persistent wage growth. That keeps household incomes growing and consumer spending elevated. While that will probably result in persistent inflation pressure, it will also give the Fed room to hike without rapidly curtailing growth. That said, it is very difficult for a central bank to achieve a perfect soft landing. The rule of thumb is that it takes six to 18 months before the effect of rate hikes are felt in the real economy. So the Fed doesn't know in real time when it has tightened too much. All it can do is react to the data it is seeing in the moment. It will be especially difficult if inflation remains high, because as long as that is the case, the Fed will probably have to keep hiking lest it damages its long-term credibility. Moreover, the only way the Fed can actually influence inflation is by curtailing aggregate demand. But, would the Fed cause a recession to restore price stability? Powell was asked this very question during his presser and probably will keep getting this question. Ultimately the answer is an unequivocal yes. The Fed cannot allow inflation to remain this high no matter what it takes. Powell knows this. I think a recession is a long way off, but I'd encourage readers to appreciate the Fed's resolve. No amount of stock market pain or rise in unemployment will forestall monetary tightening, if, in fact, inflation remains this high.

As First Rate Hike Lands, Know the Fed Is Dead Serious About Prices

Would the Fed cause a recession to restore price stability? Let's tackle that question and many others after the FOMC meeting.

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