“Slowly I turned, step by step, closer and closer” is the critical pivot in a classic vaudeville routine of the first half of the twentieth century, associated, most often, but not exclusively, with the Abbott and Costello Show. The hapless protagonist (Bud Abbot in the iconic case) enters an innocuous conversation with a seemingly mild-mannered stranger. After an innocent-sounding triggering phrase is uttered (“Niagara Falls”), the stranger darkens to relate a violent act suppressed in memory. With this pivot in the conversation, dark history repeats as the protagonist becomes victim until general mayhem snaps the stranger back to reality.
In current circumstances, the trigger was when investors expressed concern to the affable-seeming chair of the Federal Reserve (Fed), Jay Powell, about his commitment to preserving the Fed’s inflation goal. Step by step, his institution put the beginning of the removal of policy accommodation on the table late last year. Inch by inch, they admitted inflation would raise by more and for longer than previously asserted. Closer and closer, came a few, then more, quarter-point hikes in the plans of its policy-setting group, the Federal Open Market Committee (FOMC), and in latest weeks many of its members extolled the virtues of one-half-point moves. The pivot foreshadows a repetition of the volatility inflicted in financial markets whenever the Fed hikes rates to quell inflation worries. That is, unrest ensues until the Fed eventually stops tightening.
We believe the FOMC will front-load its increase in its policy rate of 2-1/4 percentage points in 2022 before pausing at the turn of the year. However dramatic this action by recent standards, we believe inflation will remain uncomfortably above the Fed’s two percent goal for the foreseeable future, which we take as a policy mistake.
Where matters last stood at the meeting on March 15-16 of the FOMC, the summary forecast of policymakers was that inflation would end the year at 5 percent and fall further in 2023, considerably more benign than other forecasts, and policymakers penciled in seven quarter-point interest-rate hikes this year. At the meeting, the FOMC guidance about the economy and interest rates was woefully insufficient in acknowledging the scope of the inflation threat and timid in its policy thrust in our opinion. Multiple Fed officials have lately endorsed 50-basis-point hikes in an increasingly booming volume, a resolve that was not displayed in the immediate wake of the meeting but emphasized in the minutes published three weeks later. Turn down the volume on Fed speakers as they struggle to regain the high ground of public opinion as events are in charge.
Late in the turn and initially slow in the delivery, the Fed finds itself with consumer price inflation running at 8-1/2 percent, a forty-year high, and worries about inflation at the top of polling lists of concerns of the American public at a time when there is so much else about which to worry.1 Given the scale, scope, and apparent persistence of inflation, half-point policy hikes are in train. Our forecast is that three in a row will commence at the meeting to be held from May 3 to 4 before the Fed slows down later in the year with two quarter-point hikes followed by a pause at the end of the year. In our view, late in 2022, inflation will have come off its peak, financial market conditions will have tightened considerably, and the unemployment rate will be rising. Moreover, six new participants at FOMC meetings will likely be more dovish than the current incumbents, making it difficult for Chair Powell to keep the group together. Indeed, we think that some of the urgency of the current cohort in planning on half-point hikes come from considering their future colleagues.
Even without a pause, what they now appear to be planning will likely still not be enough to get inflation down as quickly as they hope. The supply shocks hitting the global economy are considerable, the cost-price spiral is widening, and inflation expectations are a one-way bet higher. Despite the Fed’s more aggressive tone, we believe the nominal policy rate will track below inflation this year and into next. Unconventional tightening in the form of running off assets (to be announced at the upcoming meeting) will modestly trim a still-large balance sheet, suggesting only a small proportional change in the Fed’s footprint relative to private sector holdings. In our view, the result will sustain inflation well above the official two-percent goal, somewhere around 6 percent at the end of this year and 4 percent in 2023.
Still, this could be the beginning of a firming spell on par with 1994 and 1995. The macroeconomic result of that one is to be wished, as it was the only hiking episode skirting recession in the modern era. Wishing, however, is not a viable investment strategy (a topic covered recently in our note on recession risks).
1Source: The Bureau of Labor Statistics. As of March 2022.
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