For the record.

The Fed has delivered the most aggressive start to a tightening cycle on record, with 375bps of rate hikes in the last 8 months, but the full impact has yet to be felt. As we’ve previously discussed, rate hikes take 9-12 months to filter through the system, and the Fed has certainly front-loaded the hikes. So where does the Fed go from here?

For reference, the 2004-2006 tightening cycle increased the policy rate 425bps over 24 months. The 2015-2018 tightening cycle increased Fed Funds by 225bps over 36 months. This equates to an average monthly increase of about 18bps/month and 6bps/ month for the 2004 and 2015 tightening cycles, respectively. The Fed is currently averaging almost 47bps/month of tightening this cycle!

And compared to every tightening cycle since 1958, the pace of this year’s rate increases stands out.

So it is no surprise that the Fed will slow the pace of tightening. Keep in mind that this also does not account for the effects of quantitative tightening as the Fed continues to unwind its balance sheet.

But the Fed, particularly Chairman Powell, is painfully aware of the mistakes made by the Fed under Volker’s reign during the last inflation spike in the early 1980s. Volker pushed rates significantly higher to counter runaway inflation but started cutting rates too soon, and inflation spiked again. Volker eventually got inflation under 5%, but it took over three years and two US recessions to accomplish the goal. A price Chairman Powell hopes to avoid.

What Chairman Powell said.

Just this week Chairman Powell spoke at the Brookings Institute, where he reconfirmed market expectations that the Fed would be slowing the pace of tightening but not taking its foot off the gas quite yet. One quote from the speech summarizes it nicely:

“The time for moderating the pace of rate increases may come as soon as the December meeting…Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.”

What Chairman Powell meant.

In other words (or what Powell wished he could say), “It is time to slow down the pace of hikes. Still, we need the market to expect higher rates for longer to keep financial conditions tightening. We sure hope we don’t need to hike more than an another 100bps before we can pause, as economic conditions are certain to worsen. Fingers crossed, inflation will come back down before a deep recession, and then we will cut rates to spur growth into the next cycle.”

It’s clear the Fed wants the market to price in a 50bp hike in December, then a few additional hikes over the following months, followed by a pause at the peak rate. Markets are pricing in a similar path for Fed Funds, but have the Fed starting to cut rates at the end of next year vs an extended pause at the peak rate.

The ideal scenario for the Fed is they hike rates up to roughly 5.0%. They can then take a short pause as inflation drops back into the 2.0% range while hoping the US achieves the fabled soft landing. After that, start cutting rates to jump start the economy into the next expansion cycle (or at least pull it out of a recession). Simple enough, right?

Unfortunately, some factors are outside of the Fed’s control. China Covid lockdowns, Russia/Ukraine war, and a global recession are just a few that will play a role in determining how deep and how long the economic slowdown will be.

Jobs report.

The market expected the November jobs report to show continued softening in the labor market, with economists projecting 200k jobs added (with the whisper number being much lower) and wage growth slowing to 0.3% for the month. That turned out not to be the case, as the US added 263k jobs last month and wages increased 0.6%…not what the Fed or the market wanted to see to keep the ‘upcoming pivot’ dream alive.

Powell said earlier in the week that the labor market was only showing “tentative signs” of “rebalancing” while wage growth is “well above” levels consistent with 2.0% inflation. This report certainly did not help.

Richmond Fed President Thomas Barkin recently commented, “Increasingly, I fear we are moving to an environment where labor is short, not long…theFed has taken aggressive action to bring inflation under control, raising the Fed Funds rate steeply to just under 4% and making clear our intent to do more. Even so, we have seen labor demand continue to run ahead of supply.”

As the labor supply remains constrained, it keeps upward pressure on inflation as firms must spend more to attract and retain their workforce.

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