The Fun Is Back at Last in This Week’s Fed Meeting: Macro Man

(Bloomberg) — It’s kind of fun for the Fed to be relevant again, isn’t it? To be sure, Wednesday’s meeting isn’t a “live” one from the perspective of interest rate or QE policy; no one expects either one to be changed. But when forward guidance forms the vanguard of your policy armory, you have to deal with expectations — or at least excitement — over a potential shift when underlying conditions change. That’s the situation confronting the Fed this week as speculation over a shift in the dot plot percolates throughout the market. What makes it particularly spicy is that it isn’t altogether clear how the bond market will react, no matter what the outcome.

• It’s going to be fascinating to see how Jerome Powell and the Fed characterize the economic situation on Wednesday. Obviously the FOMC’s focus has been on the labor market, and a recent talking point is that there is substantially more slack than currently suggested by headline numbers. Then again, we’ve just seen the passage of another blockbuster stimulus package that will maintain an elevated level of income for many at the bottom of the economic pyramid. Meanwhile, consensus expectations for growth this year and next have surged, and are currently well above the Fed’s own median estimate of 4.2% and 3.2% from the December SEP.

• Leaving aside the issue of inflation, where the FOMC members can basically forecast whatever outcome they like (such is the random nature of inflation modeling these days), it’s hard to avoid the notion that there will be significant upward revisions to the growth and possibly employment outlooks. The key question is whether any or many meeting participants decide to change their minds on the interest-rate outlook given the change in circumstances.

• In December, five committee members projected a rate hike by the end of 2023. That was up from four in September’s SEP and two in June. Yet as you can see from the first chart above, the outlook appears to have changed much more favorably between December and today than it did before either of those prior SEP meetings. Christopher Waller, widely thought to be a dove, will add his projections to the dot plot for the first time. This means that five people will have to shift from unchanged rates to a hike in 2023 to shift the median definitively toward a hike; four people moving will imply a median of half a hike.
• Will we get that? Frankly, I am not sure. It would almost certainly need to come from the ranks of regional Fed presidents exclusively, as the board of governors likely remains locked into a unilaterally dovish mindset. Ultimately that in turn would imply that even a median dot projecting a hike would not necessarily guarantee one … there’s a lot of water yet to flow under the bridge.
• What’s more interesting is to consider how bond markets would react to various outcomes. On the face of it, of course, projecting an earlier rate hike is hawkish, and would presumably imply the potential for a QE taper in the forecastable future. If financial markets are trading a straight Fed policy reaction function, that would naturally see the bond market sell off, particularly the belly.
• But are markets trading that way? You can construct a persuasive argument that inflation (and the Fed’s credibility in fighting it) are ultimately what is driving fixed income price action, and the central bank’s insistence in maintaining a lower-for-longer policy regime in the face of inflation fears in certain quarters of the market might imply the necessity to move faster later on … or at the very least reduce the expected real yield available on bonds over the next few years.
• Of course, any reaction over the dot plot could be tempered by a decision over the Treasury and reserve exemption from supplementary leverage ratio calculations. This meeting seems like an apt time to announce a decision; after all, the Fed’s running out of time before the exemption expires at the end of the month. If the dot plot appears to skew one way and the SLR decision another, my guess is that initially at least, the bond market will take its cues from the SLR news.
• In the fullness of time, of course, it is going to be the interaction of fundamental developments, policy, and flow that dictate the future of market interest rates (and those assets that derive valuation signals from them.) For tomorrow, it’s reasonable to expect a fair amount of noise as bond operators sift through the announcement and decide what its various components actually mean. Either way, it’s nice to have policy meetings back as a potential catalyst, even if we’re only focusing on guidance and regulation at this point.
• NOTE: Cameron Crise is a macro strategist who writes for Bloomberg. The observations he makes are his own and not intended as investment advice. For more markets commentary, see the MLIV blog.

To contact the reporter on this story: Cameron Crise in New York at ccrise6@bloomberg.net

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