Powell’s three-pronged approach to assess Fed policy tightening | The Financial Express

Powell’s three-pronged approach to assess Fed policy tightening

Fed acknowledged that past hikes and their lags in transmission will be accounted for ahead.

Powell’s three-pronged approach to assess Fed policy tightening
A substantive pivot is one that signals a different regime, like a move from hikes to a pause or from a pause to cuts.

By Madhavi Arora

FOMC: Did someone say Pivot?

Anyone looking for a “superficial pivot” in language got what they wanted, with key caveats.

Along with the 75bps hike yesterday to 3.75-4%, the post-meeting statement opened the door to possibly stepping down the size of the next hike, if the data cooperate – with Fed acknowledging that past hikes and their lags in transmission will be accounted ahead.

But that’s where the good news ended. Powell’s prepared remarks pushed back against the idea that the Fed is close to pausing – validating our long standing view that the policy navigation will be anything but easy.

Powell reckoned, given the incoming data, the terminal rates will be higher than previously expected, suggesting uptick in dots in December. While calling the ongoing rate hikes appropriate, the statement asserts the hikes will continue until the policy is “sufficiently restrictive” to return inflation to 2%.

Market reaction

US Treasuries sharply bear-flattened, with market pricing of the terminal rate at 5.10% by May 2023; The 2s10s is now around -50bp. The USD reversed pronounced weakness and strengthened. An acute 3.4% intraday sell-off in S&P 500 ended with the worst loss on a Fed rates decision since Jan’21.

A slower hike ahead is by no means a pivot

Several times Powell said it’s premature to discuss pausing. Essentially, the Fed opened the door to dialing down the size of the next hike but did so without easing up financial conditions.

Powell laid out a three-pronged approach to assess Fed policy tightening:

1) How fast to proceed

2) How high to go

3) How long to remain restrictive.

While on (1) he conceded that dialing down the pace as early as next meeting, but rest replies were hawkish enough to temper down the Pivot lovers — stressing the need to cover more ground, and to avoid the mistake of letting up too soon.

Also Read: US Fed Vs Bank of England rate hike of 75 basis points

Statements like

(i) cost of doing too little was greater than the cost of doing too much

(ii) Overtightening can be managed as they have the tools to “strongly support the economy” — clearly shakes off any fears of revisiting the zero lower bound.

We see the Committee to step down to 50bp in December, followed by further dial down to 25bps-50bps in 1QCY23 but see the risk that the labor market doesn’t cool sufficiently by then to allow them a pause.

Also Read: US Fed expectedly hiked rate by 0.75%, here’s why the stock market close lower

The Fed pivot is superficial to us: What to watch and what to own?

We would label such a “second-derivative” change of Fed and other DM CBs as superficial since it won’t settle the more material question about high the terminal rate will go.

A substantive pivot is one that signals a different regime, like a move from hikes to a pause or from a pause to cuts.

We think the pause would come in late/post 1QCY23, which is why Duration (in rates mkt) is worth owning. Cuts won’t come until late 2023/early 2024 (during a recession), which is why it’s early to own Equities for those managing drawdown.

To own anything more cyclical, investors need high-risk premia (not in evidence yet) or high-conviction answers to three, interrelated macro questions:

(1) How quickly does core inflation decline

(2) How much unemployment is required to reduce wage inflation

(3) what terminal rate delivers a soft labor market.

In nutshell, the bumpy ride isn’t over yet.

(Author is Lead Economist, Emkay Global Financial Services)

Get live Share Market updates and latest India News and business news on Financial Express. Download Financial Express App for latest business news.

First published on: 04-11-2022 at 20:16 IST