Words today, action tomorrow: the Fed fights inflation

How hawkish has the Fed turned? In this issue of Simply put, where we make macro calls with a multi-asset perspective, we take stock of its new policy regime.

Markets expected a policy pivot…

The latest Federal Reserve (Fed) policy meeting provided yet more action in a hectic quarter for central-bank watchers. In advance of what markets expected to be the Fed’s first genuinely hawkish meeting since the pandemic broke, the USD had gained about 3% since 10 November and remained firm. Fed fund markets expected two interest-rate hikes in 2022 as inflation became a political as well as economic issue, with persistent price increases eroding US President Joe Biden’s approval ratings.

Even if inflation retreats in H1 2022, the Fed needs to take action: with words today, then policy implementation tomorrow.

Going into the meeting, markets were prepared for three key developments:

• First, an updated dot plot incorporating additional rate hikes in 2022 and 2023 – in essence, accelerated tapering and interest-rate increases
• Second, revised forward guidance stating clearly that its objective of economic reflation has been achieved, and that it is now focusing on the job market and a policy pivot is warranted
• Third, in line with Chairman Jerome Powell’s pre-meeting remarks, a change in the inflation narrative: price increases would no longer be interpreted as “transient” since they are proving to be more persistent than expected

…and got a new tightening regime

The Fed revised its 2022 inflation forecast higher – agreeing with professional economists that personal consumption expenditure (PCE) inflation in 2022 was unlikely to match its previous expectation of 2.2%. It now forecasts inflation of 2.6% next year, alongside core PCE. Not only does the Fed recognise that inflation is more persistent than in September, it perceives it to be caused by macro forces. Disruption is not driving this inflation revision – demand is.

Further to the revised forecasts, a pillar of the Fed’s 2021 communications framework has been removed: the key sentence, “inflation is elevated, largely reflecting factors that are expected to be transitory”, was eliminated from its latest statement. The reduction of its asset-purchase programme has also been significantly accelerated: January purchases of bonds and mortgage-backed securities have decreased from USD 90 bn to USD 60 bn. The Fed is cutting its losses as it is now under the public and political eye.

Eye on market volatility

The Fed prepared markets well for this confirmation of policy tightening, in our view. Its December message only slightly exceeded expectations, spurring longer term rates to rise marginally, driven by real rates rather than by breakevens. The USD remained firm amid stock-market volatility.

However last night marked a regime change: the economy and markets have shifted from an ‘inflation surprise’ to a ‘monetary policy surprise’ environment. Historically, the primary difference between these states of play is an increase in volatility. Although interest-rate hiking cycles are good news – they mean the economy is strong and aim to moderate growth to a more sustainable pace – they can weigh on corporate earnings, resulting in market volatility. 

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