Can Inflation Be Tamed  Without Damaging Growth?

We want to kick-off today’s piece with a quick recap of what we heard from the Fed on Wednesday, and what we heard was decidedly hawkish. Shorter maturity Treasury yields will continue to rise as the Fed’s rate-hiking expectations get more ambitious. The question we have is whether the economy has the stamina to weather both waning fiscal and monetary stimulus in the face of increasing rates.

The Fed seems to think so, but the market remains a little more circumspect. Hence, the hesitancy of long-end yields to move dramatically higher. Also, while fourth quarter GDP was the second highest since second quarter 2000, it was driven mainly by inventory restocking and gains in exports (primarily returning international air travelers). Both factors are likely to see give back this quarter.

Early Bloomberg consensus expectations have first quarter GDP at 2.8%, still above the Fed’s 1.8%-2.0% long-run estimate of GDP, but moving in that direction.  This will be the delicate dance the Fed plays this year: trying not to severely slow growth, while at the same time wrestling inflation to the ground via rate hikes. We shall see.

What We Learned From the Fed

The FOMC meeting, and particularly the Powell press conference, were some of the most hawkish in several years. We had expected the hawkish tone that began in December to continue, but the latest round surprised even us. For now, we want to review what we expected to hear from the statement, and from Chair Powell in the post-meeting press conference, versus what we actually heard. We’ll start with our predictions then what actually happened.

  • First and foremost, while the statement won’t shed much detail on future rate hikes, Chair Powell in the press conference is likely to not push back, or otherwise disagree, with the current market outlook for four 25bps hikes this year, beginning in March.
    • They certainly did tee-up rate hikes for the March meeting but they went beyond that. Powell didn’t pushback on a possible 50bps rate hike, and he also intimated that hiking at every meeting, instead of every other meeting, is a possibility given the stickiness of inflation.
  • The statement is likely to upgrade the economic outlook, and generally prepare the market for the aforementioned rate hike in March.
    •  This was the case, and there also was some disappointment expressed by Powell that there had been no apparent improvement in the inflation picture, nor signals that inflation was about to fall. This was another indication that rate hikes will come early and often.
  • The statement is also likely to discuss the balance sheet. With quantitative easing (net purchases increasing the size of the balance sheet) set to end in March, investors want to know what will happen to the existing stock of bonds sitting in the $8.8 trillion balance sheet. There is likely to be a discussion that, with balance sheet purchases ending, run-off of the balance sheet will begin sometime in the third quarter. That is, they will slowly start to let returning principal (via prepayments, calls and maturities) not be reinvested.
    • The balance sheet was discussed, but the surprising thing was Powell commenting that balance sheet run-off would begin soon after rate hikes begin. That’s quite a bit faster than market expectations which had a more leisurely timeline of third or fourth quarter. Some chatter has it that a March rate hike will be followed by reinvestment caps being implemented at the May meeting, in lieu of a rate hike. Thus, balance sheet run-off could begin gradually, but much sooner than expected.
Source: Bloomberg

In summary, it was probably the most hawkish meeting the Fed has held in several years. The minutes, when they are released in mid-February, will be a most interesting read. Suffice it to say now that the price stability mandate is Job 1 at the Fed for 2022. Powell and company believe the economy will be strong enough to withstand repeated bouts of rate hikes (the market has nearly five projected for this year). The longer end of the Treasury curve, while giving up more yield after the meeting, remains a bit more circumspect that the Fed can and will engineer a soft landing. That’s not to say the 10-year can’t move above 2.00%. It probably will, but a move to 2.50% or 3.00% will be a heavy lift given the Fed’s coming all-out offensive on inflation.


Inventory Replenishment Drives Bulk of Fourth Quarter GDP Gains

Fourth quarter GDP growth accelerated at the highest pace in over a year, and drove yearly GDP up by the most since the 1980s. Fueled in large part by inventory restocking, GDP rose 6.9% quarter-over-quarter annualized. That follows a more pedestrian 2.3% pace in the third quarter. Bloomberg consensus had quarterly GDP rising by 5.5%.

Source: Bloomberg

Inventories alone added 4.9% to GDP as consumption demand slowed a bit, and companies furiously added to depleted supplies during the respite. Consumer consumption  grew at a 3.3% pace in the quarter, which is an improvement from 2.0% in the third quarter, but pales in comparison to the full 2021 average of  7.9% (the most since 1946). While this restocking can continue into the first quarter, at some point a give-back will occur when inventories are deemed adequate. That could prove challenging for first quarter GDP in 2022 as fiscal and monetary stimulus fade, and at the same time, consumption moderates from 2021.

Powell is betting the economy will have enough momentum to withstand the early rounds of rate-hikes, and he may be right. But it does seem as though with consumption slowly reverting to its pre-pandemic mean, once inventory restocking is complete GDP will be hard-pressed to repeat anything close to the quarter just passed. Bloomberg consensus has full-year 2022 GDP at 3.8%, which is still well above the Fed’s long-run GDP potential of 1.8% -2.0%. That will give Powell and company comfort to begin launching rate-hikes. However, keep an eye on those projections through the first half of the year. As the punchbowl of fiscal and monetary stimulus is removed from the revelers there may be some left with hangovers.

Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 1.24 1.53 1.73 1.98 2.38 2.84
0.50 1.23 1.50 1.67 1.87 2.24 2.73
1.00 1.22 1.47 1.63 1.83 2.15 2.60
2.00 1.45 1.58 1.75 2.03 NA
3.00 1.70 1.97 NA
4.00 1.92 NA
5.00 1.89 NA
10.00 NA

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Published: 01/27/22 Author: Thomas R. Fitzgerald