What to expect from the FED’s monetary policy?

Financial markets have been quite calm so far, not showing any signs that a slower and steadier rate hike cycle from the Fed would undermine the bank’s credibility and so jeopardise financial stability.

What did Powell mean when he argued that the Fed would be nimble with its rate hikes? Did he mean that the bank might rattle off a couple of quick 50-bps hikes, perhaps even intermeeting hikes, and then take a break for some months before delivering a few more rate hikes later in the year or early in 2023, perhaps followed by another break? He might, but, in reality, an elongated "boring" 25-bps per meeting rate-hike schedule seems more likely for two main reasons. The first is that domestic data is likely to dictate such action, and the second is that the Fed will be wary of shocking the market. On the first of these, domestic data, what sort of data flow might prompt the Fed to tighten in a nimble and perhaps unpredictable way? If inflation data were to soar dramatically and/or the labor market tightened much more, the Fed could, perhaps make a case for some sharp 50- bps hikes. But inflation has already soared, well above target and well above the Fed’s forecasts, and yet the bank has done practically nothing so far.

We find it hard to believe that upside surprises in inflation now would suddenly make the Fed usher through some quick 50-bps hikes. If there was a time to act quickly and aggressively, that time has already passed. The same applies when it comes to the labour market. If we look at the other side of the coin, what might make the Fed suddenly decide to hold off on further hikes to justify its new nimble strategy? Very low inflation prints or surprising surges in the unemployment rate could do so, but data is volatile and it would be unwise to put too much store on what might prove to be data anomalies. At the end of the day, the Fed seems to believe that the fed funds target should get into the area of neutrality, which seems to be up to 2.5%. Should inflation data moderate and/or unemployment rise, we think this only changes the case for the end-point (which could be lower), not the speed and pace of the rate hikes through to that end point.

A second consideration that leads us to the gradual and predictable Fed tightening cycle, and away from the "nimble" policy suggested by Powell is that the Fed has to be wary of spooking financial markets. History shows that US interest rates are not of importance when it comes to the international ramifications of its policy. Instead, it is liquidity that counts, and the danger with fast, aggressive, and unpredictable Fed rate hikes is that they could spur a dramatic flight to quality, damage liquidity conditions, and cause both domestic and international financial market dislocation as a result.

Of course, there will be many, including some within the Fed, that feel the bank can’t afford to worry about any such adverse spillover effects. Instead, it has to do what’s right for the US economy, and if that means fast, aggressive, and unpredictable rate hikes, then so be it, as the anti-inflation credibility that this will restore will not just be better for the US in the long haul, but for other countries as well. But financial markets have been quite calm so far, not showing any signs that a slower and steadier rate hike cycle from the Fed would undermine the bank’s credibility and so jeopardise financial stability.

In our view, the Fed can use this to its advantage. Of course, it is always possible that market faith in the Fed suddenly disappears and it is forced to hike dramatically to restore confidence. But we don’t think that’s likely and, unless or until it does happen, the Fed seems best served by not taking actions that could dislocate financial markets and make its job far tougher. The bottom line is that we think the Fed will ultimately hike by more than the market expects, but won’t do so in a way that fractures asset prices.