The Fed still believes that inflation is temporary

Good morning. The results of the Fed’s day were dull, and most of them were expected. But we still believe that many observers have mischaracterized the Fed’s policies and misunderstood what the Open Market Committee is saying. It’s not that the Fed is cunning; it’s just that some people ignore the literal meaning of its statement, which shows that the “Powell pivot” is a tactical adjustment of the Fed, and it is indeed still very dovish.

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Except for the name, everything else is “temporary”

The most surprising thing about the Fed’s December meeting was the news—transmitted in the notorious “dot-map”—members of the Monetary Policy Committee are expected to raise interest rates three times next year, instead of the two consensus calls.

Even this did not scare anyone. In fact, the stock market is very happy, rising by one or two percentage points. The policy-sensitive yield of the two-year U.S. Treasury bond has not changed at all. Yields on five-year and 10-year Treasury bonds rose by a few basis points. The communication strategy of the US Central Bank seems to be working well.

Some observers believe that the committee’s higher interest rate expectations and the expected acceleration in asset purchases are signs that the Fed is forced to change its approach. This is Rick Reid from BlackRock:

“However, we suggest that, as we have done for several months, this is the case when the Fed is behind the curve and needs to catch up with rapidly changing local events.”

A sell-side strategist believes that the accelerated reduction indicates that the Fed has surrendered to its “temporary” narrative:

“Inflation has obviously passed and can be considered temporary, and the Fed has admitted that it has accelerated its pace of reducing asset purchases.”

Another strategist responded to this idea:

“The increase in inflation will be temporary, and the Fed will finally put this idea behind.”

Indeed, plotting the central bank governor’s expectations for future interest rate hikes clearly shows that the Fed will raise interest rates as soon as possible. This is the plot in September:

This is the new plot:

But this is tactics, not strategy. As reported by the Telegraph, the Fed acknowledged that short-term interest rates need to rise to hedge continued inflation. This is evident in the 2022 and 2023 points. However, the median interest rate forecast for 2024 is only slightly raised, from 1.75% to just over 2%. The longer operating point remains unchanged.

The background is a very clear fact that the committee is highly unanimous that a short-term interest rate hike cycle (up to 2.5%) will ensure that inflation is temporary. The committee’s median forecast is that the personal consumption expenditure inflation rate in 2022 will be 2.6%, and the consensus is that it will be slightly higher than 2% in 2023.

In other words, inflation above the target will continue for about a year. Let’s say together now: temporary! The Fed eliminated the term, but it still thinks the same way.

As we argued forward, The bond market fully agrees with the Fed’s attitude. The five-year inflation balance has fluctuated close to 2.7% after showing a downward trend this month. The interest rate futures market is actually more dovish than the Federal Reserve: it believes that the rate hike cycle will reach below 2%.

A flat yield curve won’t be because some people It has been argued that predicting a Fed that is too late and over-tightening is wrong. It predicts that the U.S. Central Bank can easily stop inflation.

As our friend and competitor at Bloomberg, John Ossers Point out On Wednesday, consumers and most fund managers agreed with the bond market’s view that inflation will not last long. The only market signal that may express the opposite view is technology stocks that have been sold for a long time (despite the rise on Wednesday).

One explanation for this is that they are very sensitive to interest rates and expect long-term interest rates to rise. However, another explanation is that they traded at stupid prices, and the stupidity has subsided.

Jim Caron of Morgan Stanley pointed out that even if the Fed does reach a policy rate of more than 2%, this would constitute a very mild policy tightening:

“The Federal Reserve has stated that it will shift its policy to neutrality rather than tightening by 2024… The median federal funds rate in 2024 is 2.125%, while the core PCE inflation rate is 2.125%. Therefore, [a] The effective policy interest rate will be 0% by 2024. “

Federal Reserve Chairman Jay Powell’s attitude has not changed because of his remarks. He made it clear at a press conference after the FOMC meeting on Wednesday that he expressed serious concerns about the labor market, especially the participation rate. This is not someone who believes that the US economy has stabilized at a strong level after the pandemic.

The Fed’s forecast of real GDP for 2024 and beyond is an encouraging 2%. Given the weak productivity growth and population headwinds, even this may be higher than the trend.

After inflation subsides, the new “new normal” may look a lot like the old “new normal”, which worries everyone in the years before the pandemic.

The Fed, the bond market, consumers, and fund managers may all be wrong. Inflation is unlikely to continue (we Unhedged is not smart enough to predict inflation). But don’t be fooled by the Fed’s change in terminology.

Starting from Powell, everyone bet on temporaryity. If the bet loses, it will be ugly. (Wu and Armstrong)

A good book

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