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Three Key Takeaways From The Fed Meeting
Confirming what we said in “It’s Official: Tapering To Begin In November, End In July“, the FOMC today paved the way for a taper start in two months when it said “the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” Furthermore, the projected path for the policy rate in the Summary of Economic Projections (SEP) showed an even split among FOMC members between zero and one hike in 2022, slightly above the OIS implied rate.
Additionally, the median projection implied three additional hikes each in 2023 and 2024 (for six and half total by end-2024). As shown in the chart above, the market – which is pricing in just 1% Fed Funds rate in 2024 – will have an uphill climb to catch up to the Fed.
Curiously, in its commentary on the FOMC, Goldman appears to be hinting at a bit of a mutiny inside the Fed: according to Goldman’s Jan Hatzius “our best guess is that Chair Powell did not project a hike in 2022.” Is Powell about to cede control to the far more hawkish regional Feds?
In its post-mortem of the FOMC, BofA chief economist Michelle Meyer said that on the whole, the Fed meeting was another move in the “more hawkish direction.” even if the bank clarified that “this is still a very dovish Fed that is highly committed to achieving higher inflation and a hot economy. But in the face of supply side constraints and growing signs of persistent inflation, it appears that those objectives could be met earlier.”
This may explain why Goldman was wildly off in its forecast: as Hatzius notes, “the median dot implied three additional hikes in 2023 and three more in 2024, implying three and half total hikes through end-2023 (vs two in June; we expected two at this meeting) and six and half hikes through end-2024 (not reported in June; we expected five at this meeting).”
There were three key takeaways from the meeting:
1. As noted above, taper on track to be announced in November and be completed by mid-year. While the taper signal in the statement was vague – “may soon be warranted” – Chair Powell clarified in the press conference that they could be ready in the upcoming meeting (in November). Hence absent a significant disappointment in the employment data or financial market disruption, this confirms what we said two weeks ago, that tapering will begin in November and end in July.
2. Committee members are edging toward higher rates: As the Fed’s updated dot plot showed, the Committee is now evenly split between the first hike in 2022 or 2023, which brought the median up to 0.25%. The consensus is now for 3 hikes in both 2023 and 2024, leaving rates at the end of the forecast horizon at 1.75%. As Chair Powell noted, this is still decently below the long-run funds rate of 2.5%, which means policy is still accommodative; meanwhile with 2024 OIS still pegged at 1% the market’s verdict is no way the Fed can achieve this.
3. The case of higher inflation is building due to greater supply side constraints: Forecasts were boosted for core inflation modestly and Powell noted that the supply side is constrained and creating challenges for inflation. As BofA notes, “the Fed has become more concerned about persistent price pressures, although the critical test will be long-run inflation expectations, which remain well anchored. Monitoring the supply side developments will be critical:; the supply side remains constrained for both goods and labor.
The rates market interpreted Fed communications as hawkish, with the yield curve flattening, 5Y rates 2bps higher & 30Y rates 2bp lower.
This according to BofA, was driven by changes to the dot-plot and communication about tapering. Meanwhile, the US dollar initially sold off following release of the statement but subsequently rallied sharply during Chair Powell’s press conference, finishing the day higher, with lower beta FX (emphasis: EUR) underperforming. A strong probability of a November taper and, in particular, the new hawkish dot plot are likely continue to support USD in the weeks ahead, unless fears about a big policy mistake – one which potentially could force the Fed to proceed with QE – re-emerge as they did in June.
On the November Taper
While the statement was somewhat vague, Chair Powell was clear in the press conference. He noted that the criterion for substantial further progress for price stability has been met and has “all but been met” for employment, even if some cynics pointed out that is hardly the case.
File Under Not “Substantial Further Progress” Mr. Powell…
Americans on Food Stamps vs Population
2021: 42m vs. 333m
2001: 16m vs. 285m
— Lawrence McDonald (@Convertbond) September 22, 2021
Powell said he would need to see a “good” but not exceptional jobs report in September to feel comfortable announcing tapering at the upcoming meeting in November. Powell was also specific on the path for tapering, noting that the Committee expects to finish tapering by the middle of the year, indicating a preference for a monthly pace for tapering, translating into $15bn every month.
Hiking is (not) tapering
Similar to 2013, Powell reiterated that the decision to taper is different from the decision to hike, stating that when tapering starts, we will be “well away from satisfying the liftoff test.” Despite similar rhetoric in 2013, it took the bond market months to agree with this take. However, what is clear – at least according to the Fed – is that at the end of the forecast horizon in 2024, rates will still be below the long-run rate forecast, suggesting that policy will be supportive into 2025; one can only imagine what inflation will be then. Powell also emphasized the importance of long-run inflation expectations, arguing that they are higher but mostly back to 2013 levels and not particularly troubling. He reiterated that the goal of FAIT was to push up inflation expectations, which is what has been done. He also mentioned the Fed Board’s Common Inflation Expectations (CIE) measure are at reasonable levels that are consistent with the FOMC’s inflation target.
Transitory inflation is (not) permanent
Powell attributed the sharp upward revisions to inflation to greater supply bottlenecks, which may be “with us for the next few months and into the next year.” It was unclear what will happen if they are with us well into 2022, especially since the supply side remains constrained for both goods and labor, something FedEx made abundantly clear in its earnings call last night when it slashed its EPS outlook due to soaring labor and operational costs. This, according to BofA, must be a concern for the Fed, as it threatens to keep inflation more elevated than they had been expecting. The speed by which the supply side constraints ease will be extremely important to inflation risks and the timing of the first hike.
Rate market interpretation
According to BofA, the rates market interpreted Fed communications as hawkish although this is somewhat suspect in line of the sharp curve flattening; in fact one could almost argue that the rates market indicated the Fed is engaging in another policy error.The hawkish interpretation was driven by the Fed’s dot plot and taper communications. The Fed’s dot plot signaled a pace of hikes that is in line with the market for end ’22, 10bps above the market for end ’23, and roughly 60bps above the market for end ’24. For the Fed to be credible, the market will have to move sharply higher, a move which will have adverse consequences on risk assets.
The Fed communication also suggests a clearer bias for 5s30s curve flattening in coming months. The announcement of taper at the Nov FOMC should have a limited impact on spreads given the US Treasury is likely to announce coupon cuts on the same day. BofA continues to favor wider swap spreads across the curve in the months ahead due to these UST coupon cuts and ongoing steps to improve UST market structure.
Finally, on a day when the Fed’s overnight reverse repo facility hit an all time high of just under $1.3 trillion, the Fed announced an increase in their overnight reverse repo (ON RRP) per counterparty cap from $80bn to $160bn. We flagged this possibility in August due to increased money fund utilization of ON RRP, and the increase can be interpreted as a preemptive measure by the Fed to ensure abundant money fund & GSE access to the Fed at September quarter end and in case there is a substantial flight to quality due to debt limit concerns.