Fed Races Down a Tightrope, Stepping Up a Half Point. How Far Can It Go?

The Federal Reserve may have fallen behind the curve on inflation, but Fed Chair Jerome Powell is going to try to make up for lost time. The Fed took the highly unusual step of hiking by a half percentage point at the May meeting on Wednesday. The Fed also laid out an aggressive plan to slim the balance sheet. Moreover, Powell continued a pattern of delivering a hawkish message, which he has more or less done at every public appearance over the last several months. What does it mean for the markets? Here's my take. Fed Follows Through As expected, the Fed raised its main interest rate targets by 50 basis points. While this had been widely expected for a while now, it's a big step. This is the first time since May 2000 that the Fed has hiked by more than a quarter point in a single step, breaking a streak of 26 straight rate hikes of exactly 25 bps. This is the Fed's way of acknowledging it has fallen behind the curve. There's a reason why historically the Fed has been OK with sudden rate cuts, but strongly preferred very deliberate rate hikes. Tightening monetary policy is tricky business. It is easy to hike too much and wind up damaging the economy. It took a lot for the Fed to conclude a half point hike was necessary. They really didn't want it to come to this. Powell Signals Another Half-Point Hike Soon Since this hike was well-telegraphed, traders were focused on whether Powell would endorse another half-point move in June. He was asked about this during the presser, and while he avoided anything overly specific, he said that additional half point hikes are on the table. Sounds like another 50bps hike in June. One heads up for the July meeting, where we'll get a new dot-plot. The March dot-plot had the median for 2022 at 1.75%, which effectively was one quarter-point hike at every meeting. If the Fed is already planning on a second half-point hike in June, the dots almost have to be moving higher. I'd guess the median is at least 2.25%. Yes, I know, the Fed might pause later in the year, but I don't think that is the plan right now. I think any kind of pause in hikes will be in reaction to data suggesting inflation or the economy or both are slowing. I think it is most likely that the current plan is to hike another half point in June and then quarter point every meeting thereafter. It's Official: QT In addition to the rate hike, the Fed also officially announced its plan for quantitative tightening, or QT. We more or less knew the basic outline based on speeches as well as the minutes from the March FOMC meeting, but now we know the specifics. The Fed will look to reduce its balance sheet starting in June by up to $30 billion in Treasuries and $17.5 billion in mortgage bonds (MBS). Those caps will rise to $60 billion and $35 billion respectively between June and September. This will be achieved strictly by letting securities roll off, at least for now. What that means is that if there aren't $60 billion in Treasury maturities or $35 billion in MBS redemptions or both, then the balance sheet will shrink by some smaller number that month. Given how high mortgage rates have risen lately, the pace of mortgage refinancings has plunged. Hence it is very unlikely that the MBS maximum will get hit very often anytime soon. Powell himself acknowledged this during the presser. Hawkish Powell Still Flexible During the press conference, a few reporters tried to pin Powell to some forecast about future Fed rate hikes, including the June meeting, but also questions about where neutral is -- or where the Fed plans on going for the rest of 2022. He wouldn't give in to saying anything terribly specific, but seemed to emphasize the potential for more aggressive action to combat inflation. This is clearly an intentional strategy. The Fed knows its credibility took a hit when the whole inflation will be transitory thing didn't work out. He's trying to regain that credibility by emphasizing that anything is on the table. The Fed will do whatever is necessary to get inflation back under control, and Powell is going to repeat that message every chance he gets. This is having two related, but separate effects on markets. The first is that intermediate to longer-term bonds are reacting to data more so than immediate Fed strategy. In other words, bonds in the 3-10 year area have to figure for themselves what it will take to curb inflation, because all the Fed is saying is whatever it takes. The second effect is that it has removed any sense of an upper bound on Fed policy, which in turn makes it hard for traders to take the long side of bonds in that 3-10 year part of the curve. Or put another way, traders have to be open to the possibility of Fed Funds going to 4% or 5%, where the Fed stopping at 2% or 2.5% seems like a remote possibility at best. This is why we haven't seen much buying at levels that historically have brought out longer-term yield buyers, like global banks, and insurance companies. At some point the market will probably over-price Fed hikes and there will be a meaningful rebound in bond prices. We could even be over-priced right now. But I think it is a tough trade with natural buyers sitting on the sidelines. If you have been sitting in cash and you are likely to have a long-term strategic allocation to bonds, this is probably a pretty good entry. But if you want to play it as a trade, I'm not sure what the upside catalyst is near-term. Why Not Hike 75bps? St. Louis Fed President James Bullard has been outspoken in his advocacy of even more aggressive tactics. I don't think Bullard has a ton of credibility within the FOMC, but he does have a point. Powell said that 75bps hikes aren't something the Fed is actively considering, but why not? If the Fed is behind the curve, why not move even faster? I think there are several reasons not to do this, but the most obvious is that the Fed doesn't need to. The markets have already priced in the Fed getting to 2.5% by year-end and about 3.25% by the middle of 2023. Because of this, longer-term yields have already risen substantially, far outpacing the speed at which longer yields have risen in past cycles. As a result, the economy is feeling the effects of rate hikes that haven't even happened yet. For now, all the Fed needs to do is follow through with the hikes markets are already anticipating and watch how the economy responds. The market doesn't need a shock to realize the Fed is serious. Indeed Powell said he wanted to avoid adding uncertainty to markets, which would seem to take any kind of intentional shock off the table. The way forward markets are priced, the market already got that message. For what it's worth, even Bullard seems to agree, as he voted for the half-point hike at this meeting. Could Inflation Be Peaking? I've written a couple times about what to watch to see if inflation is starting to subside. The one official data point we got in the past week was personal income and personal spending from the Department of Commerce. Both were strong for March, and in particular, the spending figures did not show any meaningful transition from goods to services spending. So far this year goods spending has grown by 6.1% and services by 2.7%. Goods spending is 29% above 2019 levels and 20% above the 2014-2019 trendline. As long as spending is that high, inflation probably won't ameliorate all that much. Yes, supply chains might heal some, but that's not going to be enough to get inflation down anywhere near 2%. For that, demand needs to subside. We did get one other interesting datapoint, although it is an anecdotal one. Amazon had been hiring at a breakneck pace over the last several months, but said last week that they were no longer chasing staffing capacity. Not that they were laying anyone off, but just not hiring as quickly. I emphasize that this is just a single company, and one that reported weaker earnings and therefore had an incentive to talk up cost savings. Still, this would be what a soft landing would look like. The labor market gets a bit looser not because companies cut headcount but just that they decide to get on without filling all the openings they have.

Fed Races Down a Tightrope, Stepping Up a Half Point. How Far Can It Go?

Tightening monetary policy is tricky -- hike too much and the economy could go splat. So this half point decision was a tough balancing act and a dash against time. Here's what I see down the line.

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