Sovereign Macro-FED decision and commentary

Sovereign Macro- FOMC decision and commentary

November 3, 2021

Bottom line: with the tapering business out of the way, the press conference delved around the conditions and timing and conditions for the start of the hiking cycle, likely next year.

• Chair Powell was unable to push back effectively at the question of whether he thought markets were wrong in pricing rate hikes. Powell said that the board focused on what they could control, eluding the question, and it wasn’t time to hike rates because he didn’t feel the FED was behind the curve, which wasn’t the question. In a follow up Powell said that it was possible, however, that the economy could achieve maximum employment by the second half of next year and hiking was therefore possible. So, in summary, he agreed with the market that hikes could come in the second half of 2022 which is hardly controversial since the DOTS already show one hike, and possibly two, in my opinion, in the December projections.
• Powell however took a non-committal stance about the assessment of maximum employment saying that it wasn’t directly measurable, that it evolved in time and would be an issue to be resolved empirically, a bit like what Justice Potter Stewart said about pornography in 1964.
• Interestingly, Powell started to hedge his statement with the catch all phrase of “risk management”. He said that when it came to solve the natural tension between high inflation and less than maximum employment, the FOMC would have to take a “risk management approach” meaning that if inflation remained persistently high and the job market hadn’t completely healed then they would have to make a “common sense” decision, -to possibly hike-. In my view, this shows that for now the FED is choosing to be patient with inflation because there are still unanswered questions about the evolution of the labor market such as what the labor force participation will do as the pandemic recedes. So far, the end of extraordinary unemployment benefits of the return to school haven’t improved participation significantly and Powell now wants to see if the fear to the virus recedes and whether those who “retired” go back to the job market helping push the LFP up. Powell said that the economy should provide those answers in the first half of 2022, which is when taper ends. They will taper hoping that inflation slows as supply constraints abate and labor force participation improves, and if it doesn’t pan out then they will have to hike.
• In another interesting area, the statement modified the FED’s view about the temporary nature of inflation. In the past, they said that inflation was largely due to temporary factors, and now they said that inflation “largely reflects factors that are expected to be temporary”. I don’t want to make a mountain our of a mole but when they introduce the term “expected” it involves uncertainty. I interpret the change as the FED having less conviction about the transitory nature of inflation, meaning that there may be some persistence inherited from the pandemic shock and therefore more downward rigidity of inflation and a bias toward higher rates. I see the FED taking a more flexible approach to what maximum employment means giving time for the labor market outlook to consolidate while they taper. But clearly rate hikes are on the table for next year.

Details

Statement

• Inflation largely reflects factors that “are expected to be transitory”
• Supply/demand imbalances related to pandemic and reopening have contributed to sizable price increases
• They announced that they would reduce purchases in 15bn (10 Treasuries and 5 MBS) in mid-November to 105bn and beginning in mid-December they will lower the APP to 90bn per month. With this schedule, and if there are no changes, QE will end in June as expected. Also, the communique indicated that “it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook”.
• The implementation note establishes that that the FED will rollover all treasury securities coming due and will reinvest proceeds in treasuries, same with MBS.

Press conference

• In the press conference Powell underscored the challenges facing the labor market where the resurgence of the virus had slowed progress. He was very focused on LFP which also softened in part reflecting factors related to the pandemic such as care giving needs and fears about the virus.
• Supply constraints have stayed longer than anticipated and Powell recognized that the FED doesn’t have the tools to ease those constraints and their persistence is difficult to predict as well as their effects on inflation, but later he added that we should see inflation declining by q2-q3 of next year.
• Powell didn’t exactly pushed back on market pricing of rate hikes. He said that the FED was focused on what it can control. “It is time to taper, we think, because the economy has achieved further progress towards our goals measured from last December. We don’t think it’s time to raise interest rates”.
• Powell also acknowledged that it is possible that the FED achieves its maximum employment goal by the second half of next year.
• Powell said wages were moving up strongly and cited the ECI for q3 but it was still about zero in real terms and if labor costs were to rise persistently above inflation and productivity then they would be more concerned.
• “Risk management”. When asked whether bringing back 5mn jobs with a high cost of inflation was worth it, Powell said that it boiled down to common sense, “risk management” where they have to be able to balance two risks that are in tension, inflation and employment. My takeaway from this was that at the moment they are favoring to make more progress on the labor market while being patient on inflation risks. Should these become a more tangible threat the FED would have to rebalance their approach. In other words, they would hike when necessary to protect price stability even if the labor market hasn’t fully healed.
• Maximum employment is not directly measurable and changes constantly. “You cant specify (sic) specific goals”.

 Jaime Valdivia

Sovereign Macro

Founder and Chief economist

jaime.valdivia@sovereignmacro.com