FOMC Outlook
· FOMC members have been notably quiet since their June meeting, with only Governor Christopher Waller giving a firmly directed policy speech in recent weeks. For lack of alternative guidance, the market appears to have adopted Waller’s base-case as its own.
· Two statements provide a map to the current market pricing:
o “I see two more 25-basis-point hikes in the target range over the four remaining meetings this year as necessary to keep inflation moving toward our target.”
o “I see no reason why the first of those two hikes should not occur at our meeting later this month. From there, I will need to see how the data come in. If inflation does not continue to show progress and there are no suggestions of a significant slowdown in economic activity, then a second 25-basis-point hike should come sooner rather than later, but that decision is for the future.”
· Unfortunately, neither Jefferson nor Cook have spoken recently, so we do not know how the Biden partisans on the committee will react to a hawkish vote coming from a swing voter such as Waller. Given the weight of evidence against a serious slowdown, doves on the committee might acquiesce to another 25 basis point hike with a change to the language of the statement that makes it clear that the terminal rate for this hike cycle is close at hand.
· The main argument among doves – and one that will appeal to Powell – is that the exact level of the terminal rate is inconsequential compared with the ability to keep rates higher for longer. Their argument will continue to raise the spectre of an over-shoot and subsequent recession requiring a reduction in real interest rates. The focus of the committee and the Chairman is likely to shift from tightening to maintaining real interest rates.
U.S. Treasury Market
· The yield curve has adopted a shape that would be implied by the timeline laid out in Waller’s speech, with the three-month rate fifty basis points higher than current fed funds and no signs of heading higher (Charts 1 & 2).
· Waller leaves the back end of the yield curve unaddressed in his speech, but the implications of what happens next are important. The downward sloping yield curve implies nominal rates will come down by approximately 150 basis points after reaching their terminal height (Chart 3). The natural assumption is that such a downward sloping yield curve implies recession, but this interpretation is wrong.
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