Ceci n’est pas une pi-vot
The November FOMC was largely as expected: a hawkish Fed hinting a path of the FF rate in line with the Taylor rules (peak at 5%-ish in early 2023, remaining at that level for at least a few quarters).
In our view, the rest of the press conference was mostly noise.
What is clear is that one or two months of “soft” inflation data will not be enough for the Fed to pivot. Monetary policy is set by the medium-term forecast which remains well above target. The models suggest that the incoming data might remain strong for another 4-6 months (after that, it can be a different story). In our view, the Fed will remain committed in the meantime.
Remarks
Powell: “Today the FOMC raised our policy interest rate by 75 basis points and we continue to anticipate that ongoing increases will be appropriate; we are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2%. […] It will take time however for the full effects of monetary restrict to be realized especially on inflation that’s why we say in our statement that it determining the pace of future increases in the target range we will take into account the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation. At some point, as I said in the last two press conferences, it will become appropriate to slow the pace of increases as we approach the level of interest rates that will be sufficiently restrictive to bring inflation down to our 2% goal. There is significant uncertainty around that level of interest rates; even so, we still have some ways to go and incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected“.
Comment: Translated: follow the Taylor rule, raise the FF rate to 5%-ish and then keep it there for a protracted period of time (at least 3 quarters). Unsurprising, given what the models suggest.
Q&As
How can inflation data influence the pace of rate increases?
Powell: “We do need to see inflation coming down decisively and good evidence of that would be a series of down monthly readings. Of course, that is what we would love to see, but I’ve never thought of that as the appropriate test for slowing the pace of increases or for identifying the appropriately restrictive level that we’re aiming for. We need to bring our policy stance down to a level that is sufficiently restrictive to bring inflation down to our 2% objective over the medium term. How will we know that we reach that level? Well, we’ll take into account the full range of analysis and data that bear on that question guided by our assessment of how much financial conditions have tightened the effects of that tightening is actually having on the real economy and inflation”.
Comment: monetary policy is set by the medium-term outlook, not by the near-term. The incoming data are important, of course. But the medium-term forecast is crucial. For this reason, at this point we think that in order for the Fed to pivot, the FOMC will need to receive green light from the Fed staff, which implies that the medium-term forecast needs to be (very) different from the recent ones. In our experience, 2-3 months of soft data can help but they are unlikely to trigger the necessary downward revision in the models. Therefore, we continue to think that the Fed will remain hawkish in the next 2-3 meetings.
Are you going to slow in December or do you think the bias now is for another 75bps?
Powell: “[…] incoming data between the meetings both, the strong labor market report but particularly the CPI report do suggest to me that we may ultimately move to higher levels than we thought at the time of the September meeting. That level is very uncertain though and I would say… you know we are going to find it overtime of course”.
Comment: As mentioned before, under reasonable assumptions, the models suggest that bringing the FF rate to 5%-ish and keep it there for a protracted period of time (at least 3 quarters) should be enough to disinflate the US economy. We take Powell’s words as a way to deliver this message.
What is your (or the Fed staff) best estimate of underlying inflation?
Powell: “I don’t have a specific number. There are many models that look at that and I mean one way to look at it is that it is a pretty stationary object and that when inflation runs above about that level.. for sure substantially but for some time you will see it move up, but the movement will be fairly gradual. So I think that’s what the principal models would tend to say”.
Comment: very interesting answer, very much in line with the Fed staff procedure. The general idea in the Fed staff procedure is that “underlying inflation” (or pi*) is a broad concept informed by three pillars: measures of trend inflation, measures of long-term inflation expectations, and the general equilibrium of the economy. For this reason, giving a simple answer is very complicated. The latest Fed staff forecast (inferred from the September FOMC minutes) reveals that the Fed staff estimate of pi* is around 2.5% (and remaining slightly above 2% at the end of the medium-term). In our view, the risks around the Fed staff estimate of pi* are to the upside, as the trend inflation measures suggest a reading close to 3%, long-term inflation expectations are consistent with a 2.3%-2.4% reading in core PCE, and the general equilibrium suggests (at least) 2.5%. From our latest Pre FOMC meeting package:
Are you thinking about pausing? (this was not the original question asked but Powell replied more to this question instead)
Powell: “Let me say this: it is very premature to be thinking about pausing. So, people when they hear “lags”.. they think about (a pause). (It is) very premature in my view to think about or be talking about pausing. We have a way to go. […] We need ongoing rate hikes to get to that level of sufficiently restrictive and we don’t really know exactly where that is. We have a sense and we will write down in the December meeting new economic projections”.
Comment: Comment: the Taylor rule is pretty clear. Bring the FF rate to 5%-ish first, then pause. Until the Fed will deliver a 5% FF rate in our view it will not pause.
Are wages slowing? Do you see wages having an effect on prices?
Powell: “I would characterize that [the incoming data] as sort of a mixed picture. With average hourly earnings you see… I would call it flattening out a level that is well above the level that would be consistent over time with 2% inflation. […] ECI reading this week again a mixed picture. […] Overall though the broader picture is of an overheated labor market where demand substantially exceeds supply.
Wages have an effect on inflation and inflation has an effect on wages. I think that’s always been the case; there’s always a going back and forth. The question is… is that really elevated right now? I don’t think so. I don’t think wages are the principal story of why prices are going up. I don’t think that, I also don’t think that we see a wage-price spiral”.
Comment: as discussed in a recent note (and in private meetings), wages are running well above the estimated fundamentals. Put it differently, wage and total compensation growth is way above the level consistent with the 2% target. Not only but the estimated models are even higher than what we think the Fed staff has written down in the Tealbook. Put it differently: wage growth continues to be the single biggest upside risk around the Fed staff forecast and in our estimate wages are putting some upside pressure on consumer prices (about 35-40bps).
Marginal rents vs CPI rents
Powell: “Powell talked about the methodological differences between CPI rents/OER (which capture all existing contracts) and private sector published rents (which instead capture the marginal rents) and their recent developments”.
Comment: in our experience, Powell and the Fed staff are very well aware and they do monitor *all* rents indexes. Two important points. First, marginal rents are pointing to a significant slowdown. However, our models suggest that the slowdown will not occur in the next 4-6 months. Therefore, it is hard to see moderation in core CPI before that. Second, the Fed staff (and Powell himself) knows well that the future is endogenous to monetary policy. Therefore, even if marginal rents have turned, the Fed cannot pivot now because otherwise the marginal rents would start re-pivoting again. Put it simply: in our view, the Fed will remain very hawkish for at least another 4-6 months. After that, there is a chance for a pivot.