THU 17 MAR 2022
Jay Powell’s communication today was like Volcker, but his actions were more like Bernanke. The Fed delivered a 25 basis point hike in the Funds rate, but arguably late and insufficient relative to the highest inflation in the past 40 years. To be fair, the FOMC projections in the dot plot were the most hawkish for some time relative to consensus beliefs prior to the meeting.
The key message is that the FOMC wants to get on top of inflation and they want to do that soon by driving nominal rates above neutral or long-term equilibrium. The December 2022 Eurodollar is now trading above 2% which is probably not far from nominal equilibrium, although curiously the Fed’s estimate of long term neutral actually came down in the dot plot. The way equity prices responded to news probably reflect the magnitude of the recent correction ahead of the meeting which in turn reflects the reflexive tightening in financial conditions over the past six months. Looking forward, the key question is how tight does policy need to be before inflation starts to moderate?
As we have noted recently, the magnitude of the required tightening in this cycle is complex. Market participants tend to focus on the Fed Funds Rate or short term interest rate expectations for good reason. However, the Fed also tends to influence broad financial conditions through its actions and promises (communication) and through the balance sheet (or asset purchase program).
Researchers at the Atlanta Fed have a model that estimates the impact of QE on the funds rate to determine the “Shadow Rate” or where the policy rate would be adjusted for the impact of the balance sheet. In the previous tightening cycle and again more recently, the implied “shadow rate” was deeply negative. Therefore, once the Fed started to taper the QE program that was a form of tightening. In the current cycle, the shadow rate implies that the Fed has already delivered over 200 basis points of effective tightening via the adjustment in the QE program (chart 1). If the Fed commences active reduction in the balance sheet in April (or quantitative tightening “QT”) that could contribute additional tightening of financial conditions.
In spite of the large shift in expected tightening, actual and projected rates are still below where they were in 2014. However, the unless inflation starts to moderate the committee expects to get restrictive next year. The only other time that the Fed has projected policy rates above neutral two years out was in 2018. Clearly that was a challenging phase for equities until the dovish pivot in 2019. Of course, inflation was much better behaved in that episode.
From our perch, if the Fed does take rates above the long term neutral level relatively quickly that would likely be disruptive for markets. Interestingly, the high yield market is already consistent with a material slowdown in growth (chart 2). While the yield curve has not yet given a recession signal (and recessions can take 18 months to appear after the inversion) it has flattened materially. It is plausible that this is an emotional overreaction to the potential growth outlook, but it also might be self-fulfilling if the Fed does take rates above neutral. As an aside, the estimate of long run neutral is difficult in theory and in practice. Of course, the markets will signal if or when the Fed has tightened too much.
The good news in Asia is that markets had already priced a recession, especially in China. As a result, we have used the recent rapid and emotional capitulation in regional equities to increase exposure (at the margin). However, we are not convinced that potential downside has been fully priced into the global risk proxy (the S&P500).