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Will Fed repeat monetary policy error from 2008 crisis?

In our special report we analyse the implication of the lowered CPI as well as FOMC statement this week. The Fed will probably "overtighten".

As we indicated in our weekly report, this weak is quite volatile given the very crucial data we obtained from the economy. Our medium-term outlook remains bearish on stocks, and the market continues with the downside swings after FOMC.

Inflation improved, but not enough for Mr. Powell

As you probably noticed, the CPI got lower than expected by consensus. The inflation print resulted in improvements, looking at month-over-month movements, which were notably well below estimates.

CPI, Economic calendar, source:

However, it’s better to look at the core CPI because it’s more crucial for the Fed as it excludes volatile items such as food and energy. Looking more deeply at core CPI excluding shelter, we see that there are improvements, and in this category we saw negative MoM changes.

Core CPI ex-shelter, source:

As we stated in previous inflation-related articles, shelter is the most lagging component of the CPI basket, and despite already cooling rents, it will take some months (1-3 months) to see a solid improvement in this category. In the following chart, one can see that the number of shelter item rose every month at elevated figures. This item has a very great weight in the overall CPI and thus impacts inflation significantly. Once this trend reverses, it will cause deflationary pressures. And in the case of rents, there are indicators that it will go down (based on leading indicators).

CPI: Shelter, source: Investro analytics team 

The Fed will probably “overtighten”

The Federal Reserve raised its key interest rate, the Fed Funds Rate, by 50 basis points to a range of 4.25-4.50%. The Fed did not surprise the markets with a higher or lower hike. However, the FOMC also revealed its economic projection, which was a negative surprise. We will describe it below. Compared to September´s projection, the FOMC expects a lower real GDP, a higher unemployment rate, higher inflation, but mainly a higher federal funds rate.

Read more: FTSE 100 slides despite a dovish BoE rate hike

On the one hand, the Fed expects that a higher Fed funds rate will lead to lower real GDP, but what is really strange is that they are even more hawkish and want to tighten more (look at rate in 2023), but still expect much more elevated inflation in 2023 and 2024. Our team firmly believes that inflation will go down much faster and could be significantly below their projections.

We also bring some clear notes from Mr. Powell press conference:

“There are no rate cuts in 2023.”

“I can´t promise that we won´t raise our peak rate estimate at a future meeting.”

“We anticipate that ongoing hikes will be very necessary to become sufficiently restrictive.”

The FOMC and Mr. Powell wanted to send a strong message to market participants. They will continue to tighten, but there is a possibility that it will end in the 1Q of 2023; there will be no rate cuts during 2023. They want rates to remain higher (than inflation for a period of time) and for a longer period of time, for many months. Mr. Powell indirectly said that the labor market is doing very well and that unemployment needs to go higher to reach inflation goals. Maybe they aware to bring a recession because a recession is a very sufficient way to bring inflation down very quickly.

FFR: timeframe between last rate hike and first rate cut, source: Macrobond, Ing vai Daily Shot, @SoberLook, @WinfieldSmart

The FOMC wants to keep rates higher for 9–12 months and then start slightly loosening. Since the 1970s, there has only been one time when the Fed has remained higher for a longer period of time, and that was from 2006 to 2008. In that time, it took 15 months from the latest hike to the following rate cut, and the result was overtightening and policy error (among many other issues). That is also one of the reasons why we do not believe the Fed will keep its word, for the following reasons:

  • If they will, they will create a recession (as still worsening conditions could plunge demand, lower EPS, leverage mortgage payments, etc., and continue leading indicators to deteriorate),
  • The FOMC will most likely not be forced to remain so restrictive because inflation will fall much faster than they anticipate in their economic projections. 

Also read: EUR/USD slows ahead of ECB decision

The funny thing is that the bond market just doesn´t believe Powell´s word as well as economic projections. The market did not reprice the bond yields, and the bond market is convinced that the Fed won´t keep its word and will not hold rates for longer. It is also confirmed by the great chart from @MacroAlf. See the difference between market rates, pricing via implied FFR, and economic projections.

Bond markets don´t believe the Fed Dot Plot at all, Source:

The stock price has dropped significantly in the last two days, with risk assets such as the Nasdaq dropping more than 4% and the S&P 500 dropping more than 3%. It is not an absolute surprise. Our negative outlook for stocks and positive outlook for bonds remain unchanged.

Disclaimer: The fully covered text is not investment or trading advice. It represents only the author’s point of view and thoughts, and we do not bear responsibility for your potential loss. The article serves only for analytical and marketing purposes.

Our Investro Analytics Team is made of financial experts and professionals who are creating content for you from all around the world. They do this by sharing their insights, ideas...


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