Birds of a Hawkish Feather
R. Scott Mildrum | December 20, 2021
Editor's Note: This is part 3 of a 4-part series on Captive.com. Previous articles covered the 2021 US economic reopening and posited that US monetary policymakers should reconsider their highly accommodative policy stance. In this latest installment, we provide updates on recent developments in US monetary policy heading into 2022.
New Year—Same Fed Chair
It was a drawn-out process, but President Joseph R. Biden finally backed Jerome Powell for another 4-year term as Federal Reserve chair. Progressive Democrats lobbied for Lael Brainard, a slightly more dovish central banker. Ultimately, the administration favored continuity, which is hard to argue with, given the current landscape. While Mr. Powell's confirmation should be a relatively smooth process, the policy shift away from accommodation rarely is. Nonetheless, after navigating the global pandemic and related economic lockdowns, Mr. Powell's next act will be an attempt to orchestrate a rate hiking cycle amid persistently high inflation, tighter-than-expected labor markets, and lofty equity valuations. Mr. Powell's job will not be any easier in 2022.
The Hawkish Pivot
In early November, the Fed decided to slow the pace of its bond purchases (the taper) in a widely telegraphed move. The initial schedule called for increasing reductions of the Fed's monthly bond purchases until hitting zero by the middle of 2022. In addition, the federal funds rate remained pinned at near-zero levels, where it has been since the onset of the COVID-19 pandemic.
Only a month later, and just 8 days after being reappointed, Mr. Powell changed the narrative during a joint congressional testimony with his former colleague Treasury Secretary Janet Yellen. In a few moments, the Fed's blasé characterization of the current inflationary environment went up in smoke. The decidedly hawkish pivot on inflation started with Mr. Powell's take on the word "transitory," which had been a Fed favorite for some time. He noted that the term should be retired and highlighted that achieving maximum employment requires price stability. More importantly, he introduced the possibility of a faster taper schedule for the bond purchase program. Just like that, a reframing of the entire monetary policy discussion in this country came into view.
Now, only a scant 6 weeks since the original taper announcement and 2 weeks after Mr. Powell's ground-shifting testimony, the Fed doubled the pace of the taper to $30 billion per month at the December 15 policy meeting. With bond purchases now expected to end in mid-March, the Fed gains greater flexibility in its fight against the potential of higher inflation becoming ingrained into the economy. In fact, the newest Fed forecast projects three hikes by year-end 2022 (up from one in their September forecast) and a steeper rate path thereafter. Chart 1 shows the December and September 2021 Summary of Economic Projections (SEP) in a dot plot.
Since the onset of the pandemic, the Fed has been hyperfocused on supporting demand and maximum employment while describing inflation dynamics as transitory. Well, inflation proved to be more persistent and broad-based than Fed forecasters anticipated. Among other things, the Fed misread the magnitude and price effects of large supply chain disruptions as well as the shift in single-family home and rental markets over the past year and a half. As a result, the Fed's hawkish pivot was rather abrupt and leaves us wondering just how committed the Fed is to its recent inflation-fighting rhetoric.
As always, the proof will be in action and, given the Fed's track record of dovishness, it seems almost impossible to imagine that a material and hawkish policy shift is underway. But that is why we play the game and why 2022 could be one massive headache for central bankers.
Heed the Curves
The shape of the US Treasury yield curve is a favorite indicator of financial market participants. An inverted yield curve, when short-term rates exceed long-term rates, typically serves as a warning sign of an upcoming recession. Meanwhile, an upward sloping yield curve is generally consistent with periods of economic expansion. Today, the yield curve is relatively flat as yields across a range of maturities have converged throughout the year. While the Fed prepares to take a harder line on inflation, the shape of the yield curve suggests that the Fed might not have much work to do. Long-end yields have been falling since March, and the recent rise in front-end rates has accelerated the flattening trend. Chart 2 shows the US Treasury curve comparison.
Right or wrong, current pricing suggests that the market is not worried about a sustained inflationary environment; if it were, we would expect long-end rates to be higher, offering some compensation to investors for higher rates of future inflation. In particular, the market does not believe that the Fed will have much success moving interest rates away from the zero-lower-bound. Either the economy is too fragile and can't sustain higher rates, or inflation will compel the Fed to act too quickly, ultimately undermining the recovery.
Meanwhile, the Eurodollar futures curve, a market heavily affected by Fed policy, is also remarkably flat. Current pricing in the Eurodollar market suggests a handful of interest rate hikes in 2022 and 2023 but virtually nothing in 2024 and beyond. Not exactly a ringing endorsement of future growth and inflation.
The Treasury and Eurodollar markets agree; namely, the Fed will hike, inflation will fall, and growth will languish. During his second term, Mr. Powell needs to be particularly savvy as he attempts to maintain credibility on the Fed's inflation mandate while not undermining the expansion. No easy task, to be sure.
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R. Scott Mildrum | December 20, 2021