The US Fed made a substantial hawkish pivot at its mid-December meeting, penciling in three rate hikes for 2022. Since then, markets have taken that message a step (or two) further, pricing in close to five rate hikes by the year-end, with whispers of a 50 basis point move in March. There are scenarios that could get us there, but we favor a more measured tightening path. More likely than not, those hefty market expectations will come under pressure from softer data in upcoming months. From where we stand today, it would not take much to get to a negative print on Q1 GDP. Would that make any difference to these expectations?
That a less accommodative policy stance is appropriate at this stage of the recovery is not in question. What is in question is the speed and extent to with which the Fed can execute on this tightening pivot without bringing the cycle to a premature end and tipping the economy into recession. Many will object to such concerns on the basis that a Fed behind the curve is a Fed that must speed up the normalization process that much more, especially since we are still at the zero lower bound.
There is some truth in the argument for accelerated tightening. Yet herein lies the conundrum: could the Fed actually be so far behind the last curve that it risks getting ahead of the next one? Meaning: will it accelerate tightening just as economic growth and inflation slow of their own accord? After all, any rate hikes that the Fed would deliver in 2022 will do very little to stem this year’s inflation problem. The real target is inflation in mid-2023 and beyond. By that point, the COVID-19 induced disruptions to global supply chains should be well behind us and inflation base effects will skew heavily in a far more favorable direction.
Perhaps, most importantly, household excess savings will have been drawn down to a significant degree, and not just among the lower income groups. That leaves future demand much more sensitive to future labor income. Unfortunately, the pace of growth in that income will be constrained by a lack of workers as the labor force participation rate has barely budged for a year. On current trends, it would not be surprising to see payroll employment gains nearly halving in 2022 despite persistently high vacancies. Sadly, vacancies generate no income and no consumer spending. Moreover, the skewed consumption patterns of the pandemic period, with abnormally high spending on goods, are bound to normalize in the coming quarters. That normalization carries risks.
It is much easier for consumption to quickly shift from services to goods than it is to shift back from goods to services. Services consumption differs from goods consumption in one fundamental way: it is not just a matter of money but also of time and saturation limits. Take the case of recreation, vacations or travel: even as many affluent consumers sit on piles of excess savings, they have no more accumulated vacation days than usual. The ability of excess savings to fuel a surge in services consumption akin to what we saw on the goods side in 2020 and 2021 and is limited.
The goods to services transition also carries risks associated with the global inventory cycle. At some point over the next few quarters, we will shift from today’s desperate accumulation phase to at least a calm flow if not outright decumulation as firms’ inventory cushion rebuilds and goods demand softens. The Q4 2020 GDP print was a stark reminder to this effect: three quarters of the 6.9% SAAR growth came from inventory accumulation. This is not sustainable in our view (Figure 1).
All this is a lot to navigate, increasing the chance of an accident. Engineering a soft landing is never easy, but it will be particularly challenging in a recovery that seems to have already begun at the “mid-cycle” mark as the post COVID-19 recovery has. Generally, much of the typical post-recession recovery phase tends to be about regaining pre-recession peaks in output and revisiting pre-recession lows in unemployment. The pure “recovery” phase of this cycle has been surprisingly short, and the swiftness and intensity of the upswing suggest a shorter duration for the cycle as a whole.
And here is the dilemma: all these comparisons suggest monetary policy should have started to normalize a long time ago. But they also suggest that the end of the cycle might be closer than we think, indicating limited runway for tightening from this point onward.
As counter-intuitive as it might sound, a careful approach would be best. It was reassuring to hear Fed Chair Jerome Powell acknowledge that “it is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate” and that there are two-sided risks to the outlook. While the market is currently focused squarely on upside risks to inflation, there are other risks on the horizon as well. In light of those risks, the current market pricing of hikes feels too onerous, especially since the Fed has also teed up balance sheet runoff soon after the first rate hike.
In fact, balance sheet reduction is another argument in favor of fewer number of hikes. The Fed is keen to move off the zero lower bound to create policy space for the next downturn, but a similar need exists in regard to the balance sheet as well. Consequently, we highly favor a dual tightening approach, with accelerated balance sheet reduction but fewer number of rates than what markets have currently priced in. On the whole, balance sheet reduction is not only the right economic move, but it should also help to mitigate an optics challenge around the Fed’s interest payments on banks’ excess reserves.
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