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I got new rules, I count em’

Dua Lipa, New Rules

Last week, we discussed the rising importance of the economic growth data in conjunction with (not instead of at this stage) inflation, both broadly in relation to central bank reaction functions and specifically in relation to the dual mandate of the Fed. Essentially we argued that the monetary policy reaction function of the Fed was evolving - as implied by the Minutes from the November FOMC.

We noted the most important points from the November Statement/Minutes, from our perspective:

  • The introduction of the term ‘sufficiently restrictive’
  • The ‘substantial majority’ in favour of soon reducing the pace of rate hikes
  • The explicit reference to the cumulative tightening to date and the long and variable lags, with which its impact will be felt
  • (in conjunction with the reaffirmation of the attainment of ‘substantial progress’ towards meeting its goals)
  • The possibility that the economy enters recession over the next year is almost as likely as the baseline and by extension the notion that “some participants observed that there had been an increase in the risk that the cumulative policy restraint would exceed what was required to bring inflation back to 2 percent”

In short, we suggested that the Fed reaction function had evolved to be more inclusive of growth considerations (not just inflation as has been the case for much of 2022). By extension the growth focus likely further reduces the upside tail risk to rates and thus the risk premium across asset classes.

Interestingly, the subsequent market response saw lower yields and higher equity markets - in other words a significant easing of financial conditions, but the dominant commentator narrative remained that inflation persistence requires an increased hawkish response to the loosening of financial conditions as the familiar inflation, rates, risk asset doom loop plays out.

Going into this week’s speech from Powell therefore, there was a significant proportion of the market that expected the Fed Chair to address, or even counter, the recent loosening of financial conditions. He did nothing of the sort.

Instead the speech focussed on the three key components of inflation (Core goods inflation, Housing services inflation and inflation in non-housing services) and highlighted the Fed view of a turn in all three (core goods most immediately as supply chains normalise, non-housing services as a function of the labour market - showing tentative signs of rebalancing and, housing services which will probably keep rising well into 2023 before turning).

Powell again emphasised the impact of previous cumulative tightening and the long and variable lags on the impact of monetary policy such that “the full effects of our tightening so far are yet to be felt.” and the implications for the active policy increment “Thus it makes sense to moderate the pace of our rate increases as we approach the level of restraint required to bring inflation down… as soon as the December meeting”

Ultimately we would argue that this is a further narrowing of the topside rate path distribution and thus should lower risk premia into year-end, at the margin lower terminal rate expectations and undermine the USD. In some respects, you could also argue that it is the emergence of new guidance, new Fed rules. We would argue that at the November meeting the Fed guided the focal point away from the policy increment and towards the terminal rate. This sentiment was also portrayed by Powell this week. However, we would also argue that Powell went a step further by emphasising not just the level that constitutes “sufficiently restrictive territory” but also how long the Fed will hold policy there before loosening.

In some ways the current backdrop from the Fed is a bit like a game of chicken. The Fed must maintain tight enough monetary settings such that inflation expectations remain anchored (or tight enough to prevent the market from losing confidence in the Fed’s commitment to its inflation mandate) and, at the same time, be careful that policy is not too tight that the Fed go beyond dampening demand in order to bring it back into better balance with supply, and crushes it completely!

We have argued over recent months that in our view there is great significance in the change in second derivative in inflation. Recent commentaries have highlighted that there is a more audible debate at the Fed about the level of neutral real rates and thus the current restrictiveness of monetary policy - the ‘sufficiently restrictive debate’. The fact that inflation is moving towards the target and not away from the target is likely to have a significant impact on the debate - especially if the other leg of the dual mandate (growth) begins to falter.

We would also argue that it is likely that going forward there is an increased risk that the evolution of inflation is non-linear. There are some obvious areas where non linearity of demand makes sense from here (and I'm sure many that didnt spring immediately to mind): (i) the demand driven inflation in the US economy was undoubtedly driven in large part by the excess savings built up as a function of Covid relief stimulus packages. Inflation has eaten into those excess savings and going forward the ability and desire of the consumer to continue to demand goods (and services) at such high nominal prices becomes much more moot. (ii) consumer confidence that drove demand through the covid recovery was likely further underpinned by sharp house price gains. Going forward, the lagged effects of monetary policy in combination with the declining confidence and wealth effects of declining house prices are also likely to lead to a non-linear impact on demand and thus inflation. (iii) Lastly on inflation the current level of absolute or nominal prices in some areas of the economy are undoubtedly unsustainable. For example the sharp jump in hotels and airfares as global demand for vacations exploded as the world reopened, is unlikely to be repeated.

The airfare model is a very sophisticated pricing model, one in which prices can vary greatly (dependent largely on customer categorisation based on seat class and duration of purchase). In essence air fares have a high responsive sensitivity to changes in demand. The ability of airlines to be able to unitise or segment customers and or seats likely means that as demand slows, prices can adjust down as well as up. Airfares were the biggest notional contributor to the 7.7% CPI print in October.

Commentator sentiment remains firmly in the camp of persistent inflation and by extension a higher Fed Funds terminal rate and a stronger USD. As the economy slows (and the global economy slows), it is likely that the reaction function of the Fed changes - particularly if, as we suspect, we are approaching non-linearity in the demand function of the US economy.

Ultimately, we continue to favour the scenario of stronger bonds (and long duration) and of a more protracted period of USD weakness. Furthermore, as the prospect of non-linear demand feeds through to the Fed analysis, it is not clear that the Fed will fulfil the expectations of the market, let alone exceed them. Second derivative change: New Rules!

Have you listened to Neil's podcast series?

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