The Fed Has Never Faced a Scenario Like This

The biggest question facing the U.S. interest rate markets is how the Federal Reserve will deal with decelerating, but still high inflation, especially if it coincides with decelerating, but still solid economic growth. Not only has the Fed never faced a scenario like this, it will also serve as the first real test of the new average inflation targeting (AIT) regime. I think there are four basic scenarios that form the framework that I'll be using to analyze incoming data. The 'Not So Transitory' Scenario The first realistic point where the Fed might act is the middle of 2022. There are three hurdles that need to be cleared before the Fed would be willing to tighten policy: Core PCE inflation is above 2.7% Unemployment is at 4% or lower Labor force participation has not meaningfully rebounded from current levels. If Core PCE is below 2.7% or so, that implies that it has been subsiding, and the Fed will be comfortable still calling it transitory and thus no need to hike. In addition, if unemployment is above 4%, it suggests the labor market has cooled significantly. I suppose if inflation were still in the high 3's, the Fed may be forced to hike anyway, but if labor growth is slowing the Fed will be very reluctant to hike. The third bullet might be the least obvious, but here's the reasoning. If it appears the labor supply is growing again, it suggests the economy will continue to benefit from easy money. Or put another way, it means the labor market can get even hotter. So if the Fed is seeing labor force participation pick up, they will be inclined to be more patient. If this is where data is, the Fed hikes immediately and probably also hikes one or two times more during calendar 2022. Transitory will be out the window and all interest rates will be substantially higher and the curve flatter. I think this scenario is fairly likely, although probably not the most likely scenario. Right now the Trimmed Mean Core PCE has run at 2.6% over the last six months. Because that measure pulls out the supply-chain spike items, it is probably a pretty good estimate of the current trend-level of inflation. In addition, if we assume labor force participation is static, it will only take 175,000 new jobs per month before unemployment falls to 4% by the middle of 2022, which should be plenty doable. The 'Lingering' Scenario If any of the three bullets above aren't happening, the next possible liftoff point is probably September. At that point there are probably two critical data points: Core PCE inflation is at 2.3% or higher, and has been steady for several months. Unemployment is 4% or lower with job gains still positive. In this scenario, inflation has subsided quite a bit from current levels, and as long as it is still in decline, the Fed might stick with the transitory narrative. Remember they are going to be paranoid about hiking too early. Inflation running at 2.3%+ will be enough to elicit a hike, but only if it appears it is settling in at that level. On the employment front, as long as job growth is even slightly positive, the Fed will still hike in the face of 2.3%+ inflation. However if it seems to have stalled completely, the Fed will assume that poor wage growth will soon pull down inflation and wait. In this scenario, the Fed hikes once but then waits a good while before hiking again, at least a couple meetings if not more. Again, they are extremely adverse to hiking too quickly this cycle. Hence, unless forced to do so, expect a halting hiking cycle, especially in the early going. In this scenario bond yields are roughly unchanged to somewhat higher, depending on how strong general growth is perceived to be at the time. In other words, the perceived terminal rate will matter quite a bit. Currently a terminal rate around 1.50-1.75% is what is priced into forward markets. If that is still the view when the Fed makes its first hike, yields won't change that much. If the hiking cycle is seen as reaching 2% or higher, yields will also have to be higher. The 'That's About Enough' Scenario If an autumn 2022 hike doesn't happen, then we are probably looking at year-end. At that point the bar for liftoff gets pretty low. Core PCE at or above 2.1% and not obviously declining Employment growth high enough to keep unemployment at least steady This more or less describes the situation that Fed Vice Chair Richard Clarida discussed in a speech in August. He said this would be enough for him to support rate hikes in Q1 2023. Whether they decide to hike at the end of 2022 or beginning of 2023 is of little moment. If this is how it plays out, immediate further rate hikes are highly uncertain. The Fed will definitely wait a few meetings before hiking again, and if there are any signs of inflation slowing further, they will pause. Optically, the Fed probably doesn't want to see inflation print below 1.9% or so for a year or more after the first hike. So even if employment growth remains strong such that unemployment falls well below 4%, if inflation seems to be decelerating, the Fed will probably wait to keep hiking. I'd guess that if we get to year-end 2022 it probably means that bond yields are little changed over the course of next year. This will probably come amidst high volatility though, as is typically the case as markets feel out the start of a hiking cycle. My own view is that the economy will most likely remain strong and ultimately the Fed hikes to at least 2019 levels (1.75%), implying a higher and flatter curve, but in this scenario that will still be hotly debated. The 'Inflation Abyss' Scenario If at any point during calendar 2022, inflation falls below 2%, all bets are off. That will probably spook the whole FOMC into remaining on hold for a long time to come. Moreover, the market will likely react swiftly. Global investors used to zero (or negative) long-term yields may conclude the U.S. is headed there too, and buy up whatever yield remains. The 10-Year Treasury would almost certainly fall below 1% fairly quickly. I don't think this scenario is very likely, but it can't be ruled out. How to Tell Which Scenario Is Developing There are three major things I'll be watching to determine which scenario appears to be playing out. First is consumer income. Stimulus is behind us but consumers still have a lot of built up savings. I expect that higher wage income will take over where stimulus left off, but we need to watch for evidence. The second is actual consumer spending. I expect retail sales will run sideways for a while, but unless it actually falls toward the old trend, that will keep the strain on supply chains. Right now retail sales are 12% above the 2011-2019 trend. Source: U.S. Census Bureau The last, and most important, is whether inflation keeps broadening out. As I've written previously, it is no longer the case that a very narrow set of goods are the only thing driving inflation higher. I mentioned above the Trimmed Mean measure being at 2.6% over the last six months. That number has accelerated from 1.7% at the start of the year, suggesting that inflation is becoming more pervasive. I believe more pervasive also means more lasting.

The Fed Has Never Faced a Scenario Like This

How will the central bank deal with decelerating, but still high inflation, especially if it coincides with decelerating, but still solid economic growth?

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