Neutral Wanted-To-Be
No big surprises. The outcome of the October/November FOMC meeting was as expected: the FOMC statement was nearly identical to the previous one and the FF rate was left unchanged, as largely discounted. As usual, we discuss Powell’s answers below. To us, Powell indented to be “neutral” and postpone any discussion to the December FOMC leaving all options on the table. As expected, he seemed comfortable with the rise in long-term yields which are expected to help the Fed under certain conditions discussed by Powell himself.
In our view, as we have been arguing for a while, the baseline is that the Fed is done hiking. Admittedly, we are marginally less sure after the September PCE report (our note here) because the FOMC can easily sit at the December table with the 3m/3m of core around 3%+. In any case, for the time being, it is pretty clear that we are dealing with a neutral Fed. The data and a new player in town (unsurprisingly, the Treasury) will move the markets. Long-term yields are taking a break for now, but in our view all issues remain on the table.
Q&As
Question. To what extent the rise in long-term yields supplant action by the Fed at this meeting?
Powell. “We’re attentive to the increase in longer term yields which have contributed to a tightening of broader financial conditions since the summer. As I mentioned, persistent changes in broader financial conditions can have implications for the path of monetary policy. In this case, the tightening we’re seeing from higher long-term rates, but also from other sources like the stronger dollar and lower equity prices, could matter for future rate decisions, as long as 2 conditions are satisfied. The first is that the tighter conditions would need to be persistent. And that is something that remains to be seen. But that’s critical. We’re, you know, things are fluctuating back and forth. That’s not what we’re looking for with financial conditions. We’re looking for persistent changes that are material. The second thing is that the longer-term rates that have moved up, they can’t simply be a reflection of expected policy moves from us […]. It does not appear that an expectation of higher near-term policy rates is causing the increase in longer-term rates. So, in the meantime, though, perhaps the most important thing is that these higher treasury yields are showing through a higher borrowing cost for households and businesses. And those higher costs are going to weigh on economic activity to the extent this tightening persists.”
Note: In the prepared remarks, Powell said: “Financial conditions have tightened significantly in recent months, driven by higher, longer term bond yields, among other factors, because persistent changes in financial conditions can have implications for the path of monetary policy. We monitor financial developments closely in”)
Comment: This is the answer we expected from Powell for the reasons we have explained using FRB-US to simulate a shock to the term-premium (our note is here). There is little doubt that a large rise in the 10y yield does “a lot of the heavy lift” for the Fed, and does affect future decisions (reminder: the model suggests that the impact is not on the terminal rate but on the duration of the “for longer”).
Question. You saying that you are not sure that financial conditions are tight enough to finish the job. Is that correct?
Powell. “Yes, that’s exactly right you know. To say it a different way, we haven’t made any decisions about future meetings, we have not made a determination, and we’re not I will say that we’re not confident this time that we’ve reached such a stance. We’re not confident that we haven’t, and we’re not confident that we have. And the way we’re going to be going into these future meetings is to be, you know, just determining the extent of any additional further policy tightening that that may be appropriate to return inflation at 2% over time.”
Comment: This answer is also unsurprising because all models continue to suggest that core PCE price inflation might remain above target going forward conditional on the September dots. Until the models will send a different signal, it will be vurtually impossible for the Fed to be confident.
Question. How does the tightening in financial conditions translates into rate hikes?
Powell gave a very generic answer and did not provide an estimate. He said that it is too early to assess ,hand that it also depends on how long conditions remain tight.
Comment: This answer was a bit surprising because we are pretty confidenent that the Fed staff has come up with an estimate of the impact from the shock. In any case, we again defer the reader to our note on this point (here).
Question. Have you changed your mind about whether it is inevitable to have “pain” on the labor market to reach the 2% target?
Powell. “Everyone has been very gratified to see that we’ve been able to achieve, you know, pretty significant progress on inflation without seeing the kind of increase in unemployment that has been very typical of rate hiking cycles like this one. So that’s, that’s a historically unusual and very welcome result. And the same is true of growth. You know, we’ve, been saying that we need to see below potential growth. And growth has been strong, but yet we’re still seeing this. […] I think, still believe that is likely to be true. It is still likely to be true, not a certainty, but likely that we will need to see some slower growth and some softening in the labor market to get to, you know, to fully restore price stability. […] And I think we know why, you know, since we lifted off, we have understood that there are really two processes at work here. One of them is the unwinding of the distortion of both supply and demand from the pandemic and response to the pandemic. And the other is, you know, restrictive monetary policy, which is moderating demand and giving the supply side time to time to recover. So, you see those two forces now working together to bring down inflation. But it’s the first one [that] can bring down inflation without the need for higher unemployment or slower growth. It’s just, it’s supply, you know, supply side improvements like shortages and bottlenecks and that kind of thing going away. […] That is really helping the economy […] But I think those things will run their course, and we’re probably still going to be left.. we think and I think we still be left with some ground to cover to get back to full price stability; and that’s where monetary policy and what we do with demand is still going to be important.”
Comment: This answer is a bit long but almost perfect. The estimates suggest that about half of the runup in core PCE price inflation was due to supply-side factors and the other half to demand-side factors. Logically, one could/should expect the first half to “go away on its own”, as supply-side issues are gradually solved (for the record: in any case, the appreciation of the Dollar triggered by aggressive monetary policy was a big player in achieving some disinflation). The issue starts with the other half which has to do with the demand-side / labor market (indeed, is it really surprising that core services ex rents/OER show no improvement what-so-ever so far?). Another way of putting it is to say that the Phillips curve is rather flat in between (say) 3.5% and 2%. A final way of putting it is to say that “the last mile is the hardest” as the sacrifice ratio is much higher. The question remains: is the Fed ready to do what it takes?
Question. How long would you be ok with 3 percent readings in core PCE?
Powell. “You know, the progress is probably gonna come in lumps and be bumpy, but we’re making progress. You know, I think the core PCE came down by almost 60 basis points in the third quarter. So, the best thing I could point to you to would be the September SEP where you know, the expectation was that inflation by the end of next year on a 12-month trailing basis would be well into the 2s and the year after that further into the 2s. So, that’s if you look historically that’s sort of consistent with the way inflation comes down. It does take some time and as you get you know, as you get further and further from those highs it may actually take the longer time.”
Comment: We agree with Chair Powell. But still, we are not quite sure whether the Fed is really committed or whether it will implicitely accept a higher inflation rate in order to save the labor market (as, for instance, FRB-US suggests).
Question. Can wage inflation at the current level push up consumer inflation?
Powell. “So, if you look at the broad range of wages, they have all really come down significantly over the course of the last 18 months to a level where they’re substantially closer to the level that would be consistent with 2% inflation over time, making standard assumptions about productivity over time. […] So I think we feel good about that. […] [However, ndr], it’s not the case that wages have been the principal driver of inflation so far […] I do think it’s fair to say that as we go forward, as monetary policy becomes more important relative to the supply side issues I talked about in the unwinding of the pandemic effects, it may be that the labor market has become more important overtime too.”
Comment: Again, we agree. However, wages are (theoretically and empirically) a fundamental determinant of the persistence of price inflation. If anything, as Powell correctly said, the behavior of wage inflation will be very important from now on to understand whether we can go below 3% in price inflation space.