The Federal Reserve today announced that they would double the speed of the QE taper to $30bn a month from January, such that net purchases will end mid-March under the current trajectory, while also voting 11-0 to keep rates on hold at the lower bound.
With these announcements largely expected, the shock delivered by today’s decision came in the form of the dot plot, which now foresees 3 rate hikes in 2022, up from just half a rate hike signalled in September’s projections.
The dot plot revisions were incredibly hawkish and exceeded our expectation of the median dot sitting at 0.5% and the broader sell-side consensus of signalling two rate hikes next year. The adjustment of the median dot up to 0.875% sent front-end Treasury yields back above 0.7% and the dollar broadly bid, while the December 2022 eurodollar futures contract was little changed as it already priced rates above 1% in the run-up to today’s meeting.
Within the statement, wording around inflation and the growth outlook has materially changed.
In line with Powell’s commentary to the Senate banking committee, the FOMC no longer view inflation as transitory, but continue to see disinflation over the near-term as supply and demand imbalances alleviate and pandemic effects fade. While on growth, the Fed has adjusted its outlook to account for the latest variant risks, but has adjusted its view based on the latest labour market developments. This view is in line with its economic projections, which have been adjusted downwards for the unemployment rate and upwards for inflation in 2022 and 2023.
The focus will now be on the press conference and whether Chair Powell shares the more hawkish outlook delivered by the dot plot. Any sizeable shift in Powell’s tone is likely to extend the dollar’s broad rally, especially against yield sensitive currencies, as back in September he talked down the importance of the dots and suggested that the core of the committee sits on the more dovish side of the spectrum. With 5 dots sat in line with just two rate hikes next year, it is highly feasible that the core committee remains marginally more dovish than the broader consensus suggests.
Update Fed projections see rates rise as early as 2022 due to expectations of a more robust labour market recovery and persistent inflationary backdrop
Post press conference: Powell more hawkish than before but still sounds more conservative than FOMC consensus
Today’s press conference provided very little in terms of additional information, meaning most of the market reaction was driven by Chair Powell’s tone in the Q&A. Despite displaying a greater sensitivity to the current inflation backdrop, Powell continued to sound more conservative than what the shift in the dot plot would have suggested as he highlighted the risks around the economic projections and reinforced the message that the dot plot is merely an indicative guide. This more conservative tone from Powell led to the initial market reaction reverting throughout the press conference, with the dollar retracing all of its gains against the euro, pound, and commodity currencies. At the same time, the 2Y10Y spread edged back to pre-statement levels as front-end rates moderated back below 0.7%.
The only other notable development came in the labour market and the Fed’s interpretation of maximum employment, which is the prerequisite to rate lift-off.
Powell reiterated his view in the press conference that the maximum level of employment will take a short-term and long-term form. Coupled with the adjustment in the 2022 unemployment projection from 3.8% to 3.5%, which coincides with the Fed’s new expectation of an aggressive start to the hiking cycle, the comments by Powell suggest that this is the level of employment required for the hiking cycle to begin unless wage pressures are absent due to a flatter Phillips curve. This will only inflate the impact of each payroll release, especially after March when net asset purchases cease.
On quantitative tightening and the timing between the end of the QE and rate hikes, Powell opted to give very little in the form of forward guidance. However, it is likely that the initial rate hike from the Fed will take place in the middle quarters of next year in our view.
Dollar declines after Powell fails to live up to expectations set by the hawkish dot plot
Author: Simon Harvey, FX Market Analyst