For “Data” we have 3 points about today’s Federal Open Market Committee meeting and Chair Powell press conference.
#1: Equity markets were relieved that Chair Powell did not put much emphasis on moving Fed Funds by 50 basis points at an FOMC meeting this year. To paraphrase his comment, “there were 7 meetings scheduled for this year before today, and the median expectation in the Summary of Economic Projections works out to 25 basis point increases at each”.
Fed Funds Futures aren’t so sure about that, and neither are many members of the FOMC. The graph below shows the current odds for various rate scenarios just after the December 14th FOMC meeting. We’ve noted the “Dot count” from the SEP in red for each potential outcome, with the modal/median estimate at 1.75 – 2.00 percent. That would work out to 6 more hikes of 25 basis points apiece, as Powell mentioned.
There are 2 problems with that neat and tidy outlook, however. First, there are 7 “Dots” (each representing an FOMC member) above the median. All of those imply either at least one 50 bp hike this year or an inter-meeting rate increase (something the Fed does not like to do outside a crisis). Second, Fed Funds Futures put an aggregate 52 percent chance of Fed Funds being higher than 2.0 percent by year end. In other words, this market is giving Powell only coin-flip odds of being right that the Fed will not end up moving by more than 25 bp/meeting this year.
Takeaway: While today’s new FOMC Fed Funds projection is a more realistic take on future monetary policy, it is still not quite where markets are pricing policy. Moreover, if just 2-3 FOMC members change their minds this year, then a 50 basis point meeting is certain.
#2: Chair Powell is confident that the US economy can withstand higher interest rates for one central reason: there are far more job openings than unemployed workers. He also cited strong consumer/business balance sheets and good wage growth, but this extreme labor market imbalance was the crux of his argument.
It was clear from his comments that the Fed hopes to tighten financial conditions just enough to have employers stop scrambling for labor and paying whatever it takes to get the marginal hire in the door. Higher interest rates should also cool consumer demand for durables and housing, the usual monetary policy pathway to affecting the real economy. Cooling the current hiring frenzy is at the top of his monetary policy “to-do list”, however.
A few statistics to put Powell’s goal in context:
- There are 4.7 million more job openings than unemployed workers.
- At the peak of the prior labor market cycle (November 2018), there were 1.4 million more openings than unemployed.
- The imbalance in 2018 was not enough to cause wage inflation (+3.4 percent). Now, it certainly is (+5.1 percent last month).
Takeaway: while the Fed is hoping for some inflation relief from factors outside its control (supply chain bottlenecks clearing, mostly), slowing corporate America’s hiring cadence is their immediate focus. Relative to prior cycles, this is a novel target for monetary policy. Nonetheless, Chair Powell made it clear today that he is willing to sacrifice some labor market strength in pursuit of lower inflation.
#3: One savvy reporter asked if Chair Powell wanted to see tighter financial conditions, and to his credit he answered with an unequivocal “Yes”. Another reporter asked about real interest rates, which remain negative, and Powell commented that he and the FOMC know that must change.
The graph below shows the scope of the problem facing the Federal Reserve. It shows 5-year real rates (blue line), 10-year real rates (red line), and the size of the Fed’s balance sheet (black line, right axis) from 2010 to the present. Three points, also annotated in the chart:
- Real rates were negative in 2012 and 1H 2013 as investors sought save haven assets after the Financial/Greek debt crises and the Fed was buying Treasuries to keep longer term interest rates low and support the US economic recovery.
- Just the mention by then-Chair Bernanke that the Fed might taper its bond purchases was enough to push real rates into positive territory. This was the famous “Taper Tantrum” of 2013.
- When the Fed started to reduce the size of its balance sheet in 2018, real rates got all the way to 1 percent. They would fall again as the market worried about Fed overtightening, and turn negative again during the pandemic crisis and its aftermath.
The issue now is that the Fed has tapered bond purchases and will likely announce reducing its balance sheet in May, but real rates are still resoundingly negative. There are only two ways to fix that. One is to convince markets that inflation is coming down quickly, which is unlikely in the near term. The second is to get nominal rates higher, and sooner rather than later.
Takeaway: nominal 10-year Treasury yields need to be 3 percent right now just to get them to a zero real rate based on current inflation expectations. At a current yield of 2.19 percent today, they have not responded much to either the Fed’s tapering of bond purchases or today’s comment by Chair Powell that runoff could start at the next FOMC meeting. Yes, this market could certainly be pricing in some possibility of a Fed policy mistake and ensuing recession. Our explanation is simpler: the Treasury market simply moves more slowly than most. We expect long term rates to move higher and suggest clients stay away from longer duration fixed income assets.