The Fed is making it clear that inflation is the priority – Plans hikes and quantitative tightening

Outlook: The markets took the Fed news remarkably well–suspiciously so. This is a market that thinks Musk buying Twitter stock is as important and interesting as Buffett buying Occidental Petroleum and HP, so perhaps we shouldn’t be surprised.

The underlying problem is that we are not prepared for inflation to persist. Or maybe equity traders deduce higher prices mean higher earnings, so that’s good. The Fed is making it clear that inflation is the top priority (over employment) and to tame it, the planned hikes and quantitative tightening are going to be huge.

The $95 billion is the equivalent of a 25 bp hike, according to Powell. So multiply that times 7 months (1.75%) plus the actual outright hikes expected (4 more at 25 bp each and 2 at 50 bp for a total of 2%) and it’s a stunning tightening, effectively 4.00% counting the 25 bp hike we already had. Fed funds was zero-25 bp only last month.

As for the rate hikes, the Fed is sticking to the data-dependency story. The problem is that the inflation forecasts are so wonky. If we believe market-based expectations, inflation in five years should be 3.28% according to FRED as of late yesterday. The 10-year is the same number. But we are inclined to agree with Oxford Economics that inflation is going to be higher, deeper and last longer, with a decent probability of 4% into the next year. See below.

If and when this sinks in, it won’t be a taper tantrum. It may well be a tsunami. The WSJ opines that inflation is a clear and present danger, and it won’t be be so easy for taper tantrum throwers to push the Fed off its plan this time. “The quantitative-tightening tantrum could go on a lot longer than the taper tantrum did.” Ah, but what does that mean for various markets?

Before considering that, don’t forget China. Depending on how far the lockdown goes and how long it lasts, the retreat in the Chinese economy is most likely, on balance, deflationary. Activity is slowing down, sometimes to a halt, meaning demand for everything is also down, including oil and factory inputs. If Covid persists in China, and that’s a big if, commodity prices can fall. See the current readings from TradingEconomics. So far this is hypothetical and we do not have estimates of how much Chinese deflation can moderate Western inflation. Meanwhile, the cost of goods imported from China may well rise.

In the days ahead, we shall see if financial market instability becomes an issue, as some Fed govs fret. If they are not going to retreat from hikes and QT, what are they going to do? The standard answer is to flood the markets with short-term liquidity. But not yet. VIX is low, showing complacency. Still, nerves are getting frayed, or should be. We see a little of that in the drop in risk-on currencies like the AUD and CAD.

We have been arguing that recession is neither imminent nor inevitable. We have an inkling we may have to retract that. Demand will drop on rising prices and critically, capital investment will drop, too, on uncertainty alone. That could take the Atlanta Fed GDPNow forecast below zero in Q2 all too easily. The housing market is going to have a heart attack with mortgage rates already over 5% and the housing shortage getting worse, in part because the cost of construction has gone up. Lumber has come down lately but see the shocking chart from Trading Economics. And remember, neither the CPI nor the PCE deflator measure true house prices, but rather owner-equivalent rents. In other words, housing cost data is rubbish.

The thing to watch out for now is fresh talk of inflation staying higher for longer and seeping into the core, with confidence in the Fed’s ability to control it starting to fade. The “institutional factor” is always the top factor in bonds and FX prices, whether it’s guidance, actions or overall credibility. The Fed delivered exactly what it said it would deliver, if a bit late, but the implications have yet to sink in. If risk-off builds, the beneficiaries will be the dollar, Swiss franc and gold. Sound familiar?

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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