FOMC preview: One and done?  

Or 25bps with more to come? Or will the FOMC surprise with a 50bps hike and say it’s not for budging? 

It’s Fed Day on Wednesday and an expected rate hike but a lot less certainty around whether the FOMC has any more plans to raise rates. Markets see a roughly 95% chance the Fed goes for another hike and roughly 80% likelihood it follows this with another 25bps hike in March. Beyond that the outlook is much less clear – only a one in three chance of another 25bps in May as markets bet that the Fed is close to the top. The meeting and press conference will be crucial as Jay Powell either pushes back against the dovish market pricing or instead leans into the narrative that inflation has peaked and a pause is warranted. 

The Fed raised rates by 425bps last year with an aggressive series of hikes. Now markets think it’s ready to slow right down with a 25bps hike on Wednesday, taking the target range to 4.5-4.75%. Slowing but not stopping seems to be the message – officials have been consistent in saying there is more work to do. 

Fed governor Waller’s comments from Nov ring out still: “We're at a point we can start thinking maybe of going to a slower pace … we're not softening...Quit paying attention to the pace and start paying attention to where the endpoint is going to be. Until we get inflation down, that endpoint is still a ways out there.” 

But the market thinks otherwise – futures point to the market thinking the Fed will stop between 4.75-5.0%, in other words one more 25bps in March after 25bps on Wednesday. Markets are also pricing in cuts later this year. But Fed officials, by way of the dot plot, think the terminal rate will be some way above 5% and stay there for all of 2023. I think even they are underestimating the scale of the problem and a 6% level is eminently possible. Ultimately, I think on Wednesday they will prefer to slow to 25bps but this is not the same as a stop and pivot – my belief is the market is mispricing the terminal rate and misjudging how long the Fed will keep them there before it cuts. 

TLDR: 25bps and more to come, raising the market expectations for the terminal rate, which ought to hit risk assets and boost the USD. In short the message should be that ‘inflation not tamed, we won’t stop until it is’.

Economic growth is stumbling 

US GDP expanded by more than expected in the final quarter of last year, however this might be the last positive print for a while as there are clear signs of deceleration at the start of 2023. Final sales to consumers rose just 0.2% in the fourth quarter and fixed investment declined 6.7%. January PMIs are in contraction territory. There are signs that the Fed’s hikes are starting to have an impact, albeit the labour market remains tight, partly for structural reasons. 

The question is to what extent the Fed will be guided by a contracting economy if inflation remains too high. So far, the Fed has made it clear it will fight inflation come what may and I don’t think this is about to change – it can and will look through soft economic data until inflation is tamed. The labour market is different, of course, since the Fed has a dual mandate. This remains in fairly good shape and although some leading indicators within the labour market suggest it could be rolling over, it remains structurally tight. 

Inflation has been rolling over, but it’s stickier 

Inflation has shown clear signs of cooling. PCE inflation has fallen from 6.3% in September last year to 5.0%, whilst core PCE inflation has declined to 4.4% from 5.2% over the same period. The thinking is that disinflation allows the Fed to slow down and signal that a final 25bps in March could be its last for now. However, slowing is not the same as coming down to target and the Fed is saying to the market that it won’t pivot soon. The setup seems to allow the Fed to slow and check the rear-view mirror. Looking forward, there are signs that inflation is broadening and become embedded to a degree that will force the Fed to push on further. Commodity inflation may be rearing its head again. 

Moreover, PMI data on prices will worry the Fed. As per Chris Williamson at S&P Global - The rate of input cost inflation accelerated into the new year, linked in part to upward wage pressures, which could encourage a further aggressive tightening of Fed policy despite rising recession risks. 

Minutes from the last Federal Open Market Committee meeting show most members reckon they should start slowing the pace of rate hikes soon. This was not a significant surprise, if indeed it’s surprising at all. Mostly we knew that the Fed was wanting to take its foot off the gas a bit as we round the corner of the year into 2023 to allow time to take a look in the rear-view mirror to see if the economy was catching up with the breakneck pace of hikes.   

Disinflation but prices are still rising