By Kevin Flanagan
Bond Strategy Manager
Follow Kevin Flanagan @KevinFlanaganWT
In the last episode of Basis Points podcast, I had as a guest Roberto Perli, head of global policy at Piper Sandler and former senior Fed official. With only three weeks and counting until May’s FOMC meeting, I thought it would be rather helpful if Roberto provided us with his unique insights into what may be on the policymaker’s mind.
Fed Funds Futures
It seems that every week, market commentators quote where the implied probability of Fed Funds futures lies. I’ve been discussing this topic for the past few weeks, but Roberto has done some interesting work on this front that I thought would be useful to share, especially what he calls the “hairy caterpillar”. The conclusion he drew was that the market’s ability to predict where the Fed will set the fed funds rate in the future has been quite poor for the past nearly 30 years, or since we have data on the forward contracts.
Will the Fed live up to expectations?
It’s one thing to say the market expects at least 200 basis points (bps) more rate hikes this year, but will the Fed actually meet those expectations or, at some point , could there be a “pullback” in the markets? Roberto noted that the Fed’s view is probably where, if the market really expects this outcome, we may as well; if the price is already included, it doesn’t cause as much of a potential problem. That being said, concerns could arise when the Fed reaches or exceeds “neutrality”. For this reason, he thinks the Fed could be very cautious in raising rates as much as the market thinks, unless it really has to, as inflation continues to remain very high. At this point, the Fed could say all it takes.
The balance sheet
We turned our conversation to the Fed’s balance sheet reduction plan, or quantitative tightening (QT). Vice-presidential candidate Lael Brainard’s recent comments were rather interesting. When it comes to balance sheet runoff, Brainard used the phrase “at a rapid pace,” but when it comes to rate hikes, terms such as “regularly” or “methodically” have been used. I posed the question: Could the Fed be more methodical in raising rates than the market expects and use its balance sheet as a complement?
Roberto mentioned that’s exactly how the Fed would think about it. There are two ways to tighten policy: one is the rate hike, the other is the balance sheet, and you can substitute one for the other. So, if you do more balance sheet, you may have to do less rate hikes. Again, inflation data will be of paramount importance on this front.
Look in the rear view mirror
I remember back in Alan Greenspan’s day he referred to looking at the CPI as looking in the rearview mirror. So, I thought a natural question for Roberto would be: do you think there’s any concern that the Fed might end up fighting yesterday’s battle?
Roberto noted that there is always that risk, and while you have to do real-time politics (and ideally looking to the future), the only thing you have to inform your opinion for the future is the past, which makes things very difficult. Right now, inflation is very high and the Fed needs to be aggressive. However, at the first sign that inflation is really moderating, Roberto thinks the Fed may think it better to slow the tightening. It will have to see concrete signs of moderation on the inflation front for it to become a little less hawkish.
Roberto pointed out that policies are forecast-based, and currently the Fed still has a pretty aggressive forecast for core PCE inflation, but if we end up seeing less than that, the Fed will be less aggressive. In the short term, he thinks the market has a good chance of being right for the next few months, i.e. the Fed will probably raise rates by 50 basis points at the next meeting and maybe also in June. In the summer, it should be clearer whether or not inflation is down as expected. If it drops, Roberto believes the rhetoric will change and the Fed will do less than it is telegraphing right now. But again, the next two 50 basis point hikes are pretty much priced in.
For those interested in the full discussion, listen to the latest Basis Points podcast here:
Originally published by WisdomTree on April 13, 2022.
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