A couple weeks ago we mulled the prospects for US monetary policy, a hot topic with the Fed on the inflation warpath, in Federal Reserve Outlook. We‘ve also posted running updates in comments, for instance in Weekly Update 20220910. With one of the most closely followed meeting announcements in memory due next Wednesday, let’s do a more comprehensive review of the rates outlook.
Fed funds futures are fully pricing in 75 bp, with a possibility of 100 bp. 75 bp is much more likely, as this Fed already views 75 as supersize and doesn’t like to surprise markets. The FOMC will also reiterate, despite its stated retreat from reliance on “forward guidance”, that it’s increasing its rate target “and anticipates that ongoing increases in the target range will be appropriate”. If it drops this language, that could be a market moving event in itself, a major dovish lurch. So if it opts for a higher headline increase of 100-125 bp, it could easily be read as no more hawkish than a 75 bp headline hike with this language.
What should it do? 125 bp, along with an explicit statement that it has no bias either lower or higher for November 2, but will rather make a de novo judgment in future meetings based on the data available at the time.
75 bp would put the Fed funds target floor at 3.00%, for the first time this cycle that the short end of Treasury yield curve is consistent with the rest, arguably a neutral policy rate. 125 bp would finally be overtly restrictive. As of today’s close, the one year rate was at 3.96% and the ten year at 3.45%. Three months at 3.20% and thirty years at 3.52%. So even at 3.00%, the overnight Fed funds target would still be lower than (in a positive yield curve relationship with) the entire Treasury market from three months to thirty years. A 125 bp hike would put it flat to slightly above the ten year. In concert with this month’s acceleration of QT, such a move could get policy out of water torture mode at the expense of a mere one shock and awe act.
But whether it were to act as expected or as wished next week, the acid test will be the effect on asset prices as a whole. The earliest likely confirmation of the Fed’s success in quelling consumer price inflation would come not in consumer price measures but in getting stock prices back to pre-pandemic levels, say at which they traded in 2018-2019; for the world roughly $75 as measured by VT, or about 3000 for the S&P, and – and this is key – without their promptly taking flight again. If they do, the victory will have been but temporary. We wouldn’t count on it.
Of course the Fed can’t say it’s targeting stock prices, but it can and does say it’s targeting “financial conditions”, and if it were to wait until consumer price inflation measures like CPI or PCE were back down to its 2% target range, it would have to bomb stocks back into the Middle Ages before declaring victory. As a welcome side effect, the wealth gap would narrow and, after much wailing and gnashing of teeth about recession, the economy would recover to a much more widely shared and sustainable new prosperity.
Long term, if the Fed feels it simply must target 2% anything, let it be nominal per capita GDP growth. 0%-3% would work, provided it also keeps an eye on asset prices. If it sees stock prices start piling on double digit annual gains again, take it as a warning. Not as proof of a new era of prosperity. Gold and copper prices should be in the mix too. Monetary policy doesn’t have to be rocket science … if it starts looking like it is, trouble is brewing.
The Fed also needs to abandon the dogma that it has to wait until there’s overwhelming evidence for a large move, then execute it in a long campaign of incremental steps, especially when it comes to tightening. The Fed should just tweak its rate target at each meeting (if not oftener) so that each move is independent of the rest … a cut or hike doesn’t imply more to come. Get the markets used to routine adjustments that don’t carry a load of baggage.
Had it been doing this, it could have easily sidestepped its “transitory” error … it could have responded to the data in a timely way, and if the inflation had turned out to be transitory, then the response could have been as well.