03.11.2022
Powell shows more than one way to tighten policy- Federal Reserve raised Fed Funds rate by 0.75% to 3.75-4.00% by unanimous decision as widely expected
- Accompanying statement made no changes to description of economy
- Guidance changed to say future hikes likely and would take account of cumulative tightening and lags, indicating a likely slower pace of tightening going forwards
- Powell explained Fed tightening worked on three levels - how fast, how high and how long.
- He said the FOMC was moving beyond the first phase and hikes could moderate as soon as next month
- But added that the peak would likely be "higher than previously thought" and that the Fed would not cut "prematurely"
- We raise our expectation of Fed peak rate to 5.00% in March and continue to expect no cuts before 2024.
Fed Chair Powell delivered a lesson in the stages of monetary policy tightening explaining that the Fed was moving beyond the initial phase of raising rates quickly to a slower pace as the Fed seeks how high rates need to go to ensure a return of inflation to 2%. However, his message was that the peak rate was likely to be higher than previously thought and that the Fed would not cut prematurely - overall a more hawkish outlook than markets had been expecting. However, as labour market resilience and inflation persistence lead to the Fed to deliver more restrictive policy, Chair Powell acknowledged that the path to a soft landing had "narrowed". We continue to expect the Fed to deliver a mild recession next year.
The Federal Reserve raised the Fed Funds target rate by 0.75% to 3.75-4.00% by unanimous decision as was widely expected by us and markets. This was the Fed's fourth successive super-sized, 0.75% hike. This meeting did not include updates to the Summary Economic Projections. Nor did the Fed chose to change the description of economic activity in its accompanying statement.
The Fed reiterated guidance that it expected further tightening "would be appropriate". However, it added that this would likely be necessary to "attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time" - implicitly acknowledging that policy is now in restrictive territory. It further added that future increases " .. will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments". Of course, the Fed would always have taken such consideration into account, but the purpose of emphasizing the cumulative tightening and lagged impact in today's statement appears to be designed to detach expectations for ongoing jumbo-sized rate hikes while inflation must surely remain elevated over the coming months. The Fed is staring Friedman's fool in the shower* analogy in the face and while it will of course continue to make decisions based on future developments, it appears to be making the case for an easing in the pace of tightening.
Indeed this was at the heart of Chair Powell's press conference. He characterised the tightening process as one of three stages - the speed of hikes, how high they go and how long they stay there. He said the Fed was thinking more of the second stage and that the question of when to moderate was less important, but "may come as soon as the next meeting or the one after". In terms of how high to go, Powell stated that there was much uncertainty over where "sufficiently restrictive" is, that there was still "some ground to cover", but that he would expect it to be higher than projected in September's dot plot. He also stated that the Fed was going to show "resolve and patience" to getting the job done implying that the Fed would likely leave rates higher for sometime saying it would not "withdraw [tighter policy] too soon".
To our minds, Powell's focus today was explaining the shift from how fast to how high - something that appeared to cause initial market confusion. In that context, and in the light of ongoing firmer-than-expected inflation, persistent surprises of labour market resilience and Powell's clear warnings, we nudge our expectations for rate hikes modestly higher, still expecting a step down in pace to a 0.50% hike in December and 0.25% in February, but adding a further 0.25% to 5.00% in March (mindful of risks of February seeing a further 0.50%). However, we think that the Fed will soon pivot from how high to how long. At 5.00% we believe there will be material headwinds to activity and that those will grow across the course of next year. We believe the Fed will still try to anticipate "sufficiently tight", rather than hike until the economy is broken and then have to immediately cut. As such we retain our view that the Fed will not cut rates until 2024.
Implicit in this assessment is how much of a slowdown this tightening will deliver. Powell stated that the Fed required a period of sub-trend growth and a softening in the labour market. He acknowledged that with more stubborn inflation and hence more restrictive policy than expected, the path to a "soft landing" had narrowed, although suggested it was "still possible". He also repeated that a softening in the labour market could be more driven by a reduction in job-openings rather than an increase in unemployment. We acknowledge the significant uncertainty around this outlook. However, our own outlook is for a more material drop in activity and we continue to envisage a mild recession next year - something that might also accelerate the Fed's move to a pause - but also expecting continued stubborn inflation to keep the Fed from cutting next year.
Market reaction was confused. As the Fed decision and statement laid out the move from how fast, markets reacted dovishly - expectations for next September's Fed Funds rate dropped by 15bps to below 4.75%, 2-year US Treasury yields dropped 13bps to 4.43% and 10-years fell by 8bps to 3.97%, the dollar fell by 0.9% against a basket of currencies and the S&P 500 equity index rose 1.3%. However, as Powell explained that the Fed's tightening was likely to be slower, but higher and for longer than had been considered, all of this sharply reversed. 2-year yields are now up 3bps at 4.59%, 10-years are up 2bps at 4.07%, the dollar is now 0.5% higher than before the announcement and stocks 1.8% lower.
