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The Fed Will Now Slow The pace Of Monetary Policy Tightening

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Economists predict the FED will now slow the pace of monetary policy tightening after the accelerated hikes from 50 to 70 bps in June.

“We think it is time for policy to deemphasize “spot” data. Financial conditions have tightened drastically, especially in housing, and – more fundamentally – data have gotten noisier in the COVID recovery, so it is not clear to us that high frequency data surprises carry much information.

“Putting a greater emphasis on forecasts rather than “spot” data will mean it is time for the Fed to pivot, i.e. slow the pace of monetary policy tightening going forward,” says the Institute of International Finance.

Analysts from the Institute says it is well known that monetary policy operates with long lags, because the transmission of policy to the real economy happens via financial conditions, where the effects on consumers and businesses are highly uncertain and variable.

Historically, they say, monetary policy has therefore always been forecast-based, whereby policy makers target inflation two years ahead.

“With the sharp rise in US inflation – to the highest levels in many decades – this forecast-based approach has, at least to some degree, given way to reacting to the level of “spot” inflation and other data.

“This shift was on full display in June when Chair Powell linked the acceleration of Fed hikes – from 50 to 75 bps – to higher-than-expected CPI inflation for May and rising inflation expectations,” they add.

The Fed And Spot Data Risks

Chair Powell in the June FOMC press conference linked the acceleration of Fed hikes to an upside surprise in CPI inflation for May.

This emphasis on “spot” inflation and other data has conditioned markets to react violently to instances where data releases are meaningfully different from consensus.

Last week’s non-farm payrolls release is a good example. Payrolls came in stronger- than-expected – a +3.1 standard deviation surprise – and the 2-year yield registered one of its biggest ever jumps (Exhibit 1). The Dollar also jumped strongly in response to this upside surprise (Exhibit 2).

“We think this focus on “spot” data carries risks, most obviously given the long lags in monetary policy transmission.

“After all, it is possible that financial conditions have already tightened sufficiently to bring inflation down on a 2-year horizon so that reacting to “spot” data may raise the risk of a hard landing. More fundamentally, the recovery from COVID has been exceptionally noisy, with the magnitude of surprises in non-farm payrolls (Exhibit 3) and core CPI (Exhibit 4) rising relative to history.

“This means that the information content in surprises has deteriorated, and it is, therefore, better not to react too much to the ongoing data flow,” the IIF says.

The broad evolution and pattern of data surprises bear this out. Exhibit 5 aggregates surprises for core CPI and average hourly earnings (AHE) to a quarterly frequency and compares them with GDP surprises. The magnitude of surprises has clearly risen over time.

It is also clear that GDP surprises are increasingly negative, even as average hourly earnings have surprised positively.

“We think the latter cannot persist in the presence of the former, i.e. weak GDP will eventually overwhelm inflation pressure, which is what has begun to happen with yesterday’s downside surprise to core CPI.

“This is why a Fed pivot to a slower pace of hikes is warranted in September. Such a pivot would also be consistent with longer-term inflation expectations (Exhibit 6), which show no sign of being unanchored,” the IIF says.

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