The Fed Takes a Big Leap as the Training Wheels Are Coming Off

Wednesday's Federal Reserve meeting was hotly anticipated, and it didn't disappoint. After several months of hawkish baby steps, the December meeting represented a big leap. For the first time, Fed Chair Jerome Powell gave an emphatic warning that tighter policy was needed and coming. Here are my thoughts on what was said and what comes next. Accelerated Taper The main action taken at this meeting was to further curtail the pace of bond purchases. Starting in January, the Fed will reduce the size of new QE buying by $30 billion per month. That's double the pace announced just one meeting ago. During his presser, Powell described this as a form of reducing policy accommodation, which is a nod to worries about recent high inflation prints. However, the direct effect of slightly fewer bond purchases is extremely minor. I seriously doubt actual inflation would wind up any different in 2022 whether the Fed stopped QE purchases tomorrow or tapered according to the original November timeline. The real reason to accelerate the tapering timeline is to create optionality to hike sooner. The Fed wants out of the QE business before starting to hike rates, so if they think a rate hike in early 2022 might be appropriate, they need to wind down the bond buying quickly. Under this $30 billion per month scheme, they will buy their last QE bond in March, opening the door for a rate hike this spring. Mission Accomplished The Fed dropped a hawkish bomb in the press release that I don't think many were expecting. They described inflation as exceeding 2 percent for some time. This is critical signaling, as the Fed's Average Inflation Targeting (AIT) strategy envisioned keeping policy accommodative until the economy reached maximum employment and inflation ran above 2% for some time. Sounds like that second goal has been reached. As far as maximum employment, Powell said during the presser that all FOMC members think this goal will be met next year. This basically means barring an extremely sudden drop in job gains, employment is no longer a hurdle to rate hikes. Dots on the Rise Speaking of April rate hikes, the Fed also released a new dot plot this month. It showed that most members think three rate hikes will be appropriate in 2022. That was definitely above consensus as most traders were expecting the median would be for two hikes. Notably, there is pretty strong consensus, with 12 FOMC members suggesting three or four hikes in '22 vs. just six for two or fewer hikes. As he often does, Powell downplayed the importance of the dot plot, saying it didn't represent a committee plan. Of course, he's right in a very important sense: the dot plot reflects where individual members would set policy rates if their own forecast came to fruition. Hence, there are two problems with taking the dot plot too literally. The first problem is that the Fed isn't a democracy. The Chair dominates decision making, and individual members have varying degrees of influence. So every dot is not actually equal. The second problem is that since the dots reflect an individual's forecast, different dots may merely reflect a more or less optimistic outlook. For example, a member suggesting three hikes in '22 may just have a stronger growth/inflation forecast than another member. It is likely that if all members were presented with a single forecast, there would be much more agreement over what the appropriate policy should be. The Right Way to Use the Dots That being said, the dots can be very helpful to making calls on what the Fed might do, you just need to use them in conjunction with the rest of the Summary of Economic Projections (SEP). It is pretty safe to look at the median forecast for unemployment and inflation, and conclude that if those come to fruition, the Fed's target rate will probably be at the median dot. In other words, this helps us determine the Fed's reaction function more so than it tells us anything about what will really happen. With unemployment already sufficiently low, the focus now is entirely on inflation. This month the Fed upped its forecast for Core PCE inflation in 2022 from 2.2% in September to 2.7% now. Now pair that with the fact that most FOMC members think three hikes would be appropriate. So one conclusion we could draw is that it would take inflation running faster than 2.7% to elicit four or more hikes. It is also interesting to consider that 2.7% would be a meaningful slowdown from where Core PCE is now (4.1%), which tells us that even if inflation starts to slow, the Fed won't wait forever to start hiking. This gets a little more interesting if we also throw in the 2023 Core PCE forecast. The median FOMC member thinks inflation slows to 2.3% in 2023, and they expect to hike three more times (to 1.75% on the upper end of the range) by the end of that year. From that we can glean that as long as inflation is somewhat above the 2% target in 2023, the Fed will slowly but continuously hike. If you use the dots in this manner, it can tell you a lot about how the Fed will interpret incoming data. Just don't forget that the actual number of hikes indicated by the median dot doesn't mean anything in and of itself. Market Reaction Bonds predictably sold off in the wake of the Fed, with shorter-term bonds moving the most as they now need to price in three 2022 rate hikes as the base case. From this point on, bond yields will be dominated by how transitory inflation turns out to be. If inflation is trending toward the low 2's by the end of 2022, then this slow pace of Fed hikes will prevail. If it slows faster than that, perhaps the Fed stops hiking. If inflation is more persistent, then markets will have to price even higher yields. What was perhaps a bit surprising is that stocks have rebounded since the Fed release despite its hawkish tone. The coming months will be an interesting test for stocks. If the economy remains strong despite a more hawkish Fed, perhaps earnings growth will be strong enough to overcome somewhat higher rates. In other words, the training wheels are coming off, and now equity markets are going to need strong fundamentals to keep rising.

The Fed Takes a Big Leap as the Training Wheels Are Coming Off

The central bank dropped a hawkish bomb in the press release that I don't think many were expecting. Here are my thoughts on what was said and what comes next.

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