Fed Chairman Jerome Powell, shown at his postmeeting press conference last month, has had to recalibrate assertions that the central bank can cool inflation without causing recession.
Jim Watson/AFP via Getty Images
Recent inflation data are something of a game-changer for monetary policy. Expectations for what will come out of the Federal Reserve’s meeting this week and beyond have quickly ratcheted higher, spelling more pain for financial markets and the economy.
Before last week’s consumer price index showed prices rose 8.6% in May from a year earlier, a fresh 40-year high, investors were sure the Federal Open Market Committee, the Fed’s policy-setting arm, would raise interest rates by another 0.5% on Wednesday. After all, Fed Chairman Jerome Powell had in May taken a bigger rate hike off the table, and subsequent Fed speak all but guaranteed half-point increases in June and July.
Then last Friday’s CPI report shocked Wall Street and seemingly unsettled policy makers, who are in a blackout period where public communication ceases ahead of a policy meeting. It got worse when the University of Michigan’s consumer sentiment survey showed a sizable increase in consumer inflation expectations five to 10 years out, and a report from the Federal Reserve Bank of New York showed one-year inflation expectations hit the highest level on record. While the latter two data points didn’t get nearly the attention of CPI, inflation expectations are crucial to the path of actual inflation. Expectations around future prices shape behavior, which in turn help determine inflation, and central bankers keep a close eye on such measures.
The bad batch of inflation data prompted some Wall Street banks on Monday to revise their Fed forecasts. Economists at Goldman Sachs pointed to a Wall Street Journal article that suggested officials would consider surprising markets with a 0.75% rate increase this week–noteworthy, Goldman says, because the story was an abrupt shift from the paper’s recent reporting.
Roberto Perli, head of global policy at Piper Sandler , says the nature of the language in the Journal article indicates that the source of the news is the Fed itself, and specifically the Fed Board’s communications office. “Our Fed experience tells us to treat this as signal, not noise,” he says.
CME data, meanwhile, show traders on Monday raced to reprice rate bets. Fed fund futures reflected 94% odds of a 0.75-percentage-point June hike, which would be the biggest since 1994.
A rate hike of three-quarters of a point on Wednesday seems the new sure thing. Here is a rundown of what else to look for, as the Fed’s meeting ends and markets and the economy absorb more aggressive policy tightening.
Are 0.75-Point Rate Hikes the New 0.5?
Up until the latest inflation data, investors thought the Fed would raise rates by a half point in June and July, with the jury out on September. Now, CME data show a nearly 90% chance of another 0.75-percentage-point hike in July.
The hope by some that the Fed would in September slow to a 0.25-percentage-point pace is all but dead, at least for now. Traders see 62% odds of a half-point increase and a 26% chance of another three-quarter-point increase at the Sept. 21 meeting. New rate bets mean markets expect the Fed to hike to about 4% by the end of 2022.
That could change. Piper Sandler’s Perli says a 0.75-percentage-point hike this week is good news because it reduces the chances that it will have to do even more later. Still, he says, significant tightening will be required to bring inflation down, and significant tightening implies high likelihood of recession next year. Data Tuesday on the state of small-business underpin recession fears.
The economists at Goldman say they now also expect a 0.75-percentage-point increase in July, but they see the pace slowing to a half-point in September and then to a quarter-point in November and December. That would leave the so-called terminal rate at 3.25-3.5%.
Financial Conditions and the Powell Put
Many economists and strategists say that with inflation where it is, the Fed has no choice but to fight it—despite the implications for asset prices and economic growth. Investors have gotten used to the Fed put, or the idea that the central bank would inevitably rescue markets from a severe downturn.
Where is it now? No one knows, though it is hard to believe it is totally dead. But the Fed needs markets to be convinced that it is serious about fighting inflation, one reason why a three-quarter-point hike now seems likely. Powell’s prior assertions that the central bank can engineer a soft, then “softish,” landing—or that it can cool inflation without causing recession—has led some to believe the central bank would prematurely stop tightening in order to protect growth and financial markets.
Officials have said they want to see tighter financial conditions, made up of things like stock prices and credit spreads. Looking at stocks alone, the S&P 500 has erased 21% while the Nasdaq 100 has dropped 31% since the start of the year. In the minutes from its May meeting, the Fed noted “increased uncertainty and ongoing volatility had reduced risk appetite in financial markets and eased price pressures, although valuations of many assets remained elevated.”
Goldman says that additional tightening of financial conditions on Friday and Monday, driven by expectations for a higher terminal rate of 4%, “would imply a meaningful further drag on growth that goes somewhat beyond what we think policymakers intend at this point.” A lot can happen between now and the end of the year, but it is too soon to hear Powell express concern about financial conditions.
New Economic Projections
Fed staff update inflation, growth and rate projections quarterly, and those new projections will be released at 2 p.m. Eastern time Wednesday.
Given the negative first-quarter reading on gross domestic product, and falling expectations for second-quarter growth, the Fed will have to revise down its 2.8% 2022 GDP estimate. For 2023 and 2024, March projections stood at 2.2% and 2%. As for inflation, the Fed prefers the personal consumption expenditure index, excluding food and energy. Those estimates in March were 4.1% for 2022, 2.6% for 2023, and 2.3% for 2024.
There is a wide gap, meanwhile, between the Fed’s March rate projections and where markets have moved. My colleague Randall Forsyth last week previewed the new summary of economic projections.
The Other Tightening
While much of the focus is on rate increases, this tightening cycle is double-barrelled and the other half—balance-sheet shrinkage—is just getting started.
This month, the Fed began reversing some of the trillions in bonds it bought in response to the pandemic over the past two years, when it came to own about a third of both the Treasury and mortgage-backed securities markets. So-called quantitative tightening is vague in part because the Fed itself has said it doesn’t know that much about how balance-sheet shrinkage will play out.
While officials have said they’d like QT to run in the background, that’s always been unlikely. And signs of trouble emerged last Friday, after the CPI report. When the latest inflation data changed the bond market’s view of the Fed’s trajectory, “the weakest sector broke,” says Lou Barnes, senior loan officer at Cherry Creek Mortgage. In bond jargon, he says, “MBS went ‘no-bid,’ ” which is to say at one point Friday there were no buyers for mortgage-backed securities.
Walt Schmidt, senior vice president of mortgage strategies at FHN Financial, notes that QT for the MBS side of the Fed’s portfolio starts Tuesday. He says he’s looking for more clarity out of the Fed this week, which has suggested it might eventually sell MBS in order to exit that market. Letting those securities roll off would take years as prepayments—often a function of refinancing—slow as mortgage rates rise.
Trouble in the MBS market may foreshadow more turbulence ahead. “So far QT has really barely started, so rate [volatility] is largely from policy uncertainty,” says Joseph Wang, previously a senior trader on the Fed’s open markets desk. He says he expects QT to have more impact on markets in the coming months when it is in full force.
As Tim Wessel, strategist at Deutsche Bank puts it, QT will have real implications for market pricing, financial stability, and Fed policy choices. And for now, it remains a question mark.
Write to Lisa Beilfuss at [email protected]
