The next FOMC policy announcement is scheduled for Wednesday. The Fed has been keeping a close eye on financial conditions as a “transmission channel” for monetary policy, and a falling dollar and soaring stocks are sensitive alarms of inflation going into the pipeline. Contrary to the prevailing market narrative, they don’t support the notion that policy is tight.
The Fed openly worried last fall that downshifting to smaller hikes would stoke an unwanted easing in financial conditions, and hoped that it could offset the risk with tough talk about a higher for longer terminal rate. It gambled and lost.
This represents an unfortunate setback after it put its credibility on the line for most of last year by vowing that it would act decisively to get inflation back to its 2% target. Markets (or at least market media) are pinning hopes that a decline in measured consumer inflation will continue. That decline is the downstream effect of the deflationary activity seen at the leading edge in asset prices and foreign exchange for the first three quarters of last year, which, however, has since gone into reverse.
If the Fed were to be consistent with its earlier stance, it would act vigorously to stomp on this renewed easing in financial conditions (inflation). But I believe it will instead double down on its prior error of substituting action with talk. It will accommodate market expectations of a 25 bp hike in the Fed funds rate target, moving the floor to 4.50%. Despite this renewed easing in financial conditions, it no longer has the cover of high and rising consumer inflation data.
In light of financial conditions, I could make a case for 50bp, even 75bp. But it’s not necessary. In fact a year ago, I would have suggested (and possibly did), that a 3.00% Fed funds floor would have been enough. But that was assuming it was timely reached. It was not, and so a higher rate was then required.
So if the FOMC would be right to hike 25 bp Wednesday, what’s the beef? Talk versus action. The FOMC will dress up the more dovish action with more hawkish talk about higher for longer. The same error it made in December. Tough talk about policy three or four meetings out does not commit the Fed to action and markets know it.
It could instead actually take action by stepping up the pace of QT. Specifically, were I in Powell’s shoes, I would move ahead with the expected 25 bp hike to a 4.50% Fed funds floor, but accelerate the runoff of the Fed’s MBS portfolio. This would send a strong message that the Fed is serious about stemming incipient inflation and keeping financial conditions from easing without pushing Fed funds even further out of whack with the rest of the yield curve. And of course if the reaction turned out to be excessive, nothing prevents the Fed from re-adjusting the pace of QT at the next meeting. Or the next week, for that matter. Just because the Fed has insensately locked itself into a rigid series-of-unidirectional-moves habit with Fed funds doesn’t mean it has to do the same with quantitative policy. If financial conditions ease too much, step it up; if they get too tight, dial it back.