October CPI Report Changes Narrative for the Fed

The October CPI report has set an uncomfortable narrative for the Fed as we approach year-end and that new narrative will make it harder for them to preach patience in the face of the highest inflation readings in 30 years. While Powell and his fellow governors likely still believe most of the price pressures are due to supply constraints that should eventually relent, it’s obvious the time line of that to happen has only increased as we have moved through the year.

Now that inflation has moved from a business page story to a front page story the public and political pressure will force the  Fed to be seen as doing something besides just preaching patience.  What that something is we explore in more detail below.

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Big Price Hikes in Many Typical Household Expenses

The October CPI report has accelerated all manner of discussions regarding if the Fed will boost its tapering schedule before it has even begun, and also if that is the precursor to bringing forward rate hikes. One of the striking aspects of the October report was the price hikes seen in items that every household feels and that will put additional pressure on Team Transitory at the Fed. When economic news jumps from the front pages of the business section to the front page, a political response usually follows.

 

Source: Bloomberg

The Fed, and particularly Fed Chair Powell, have preached patience with the supply-driven price increases as they wait for the economy to approach full employment. They may not have that luxury now to sit back and wait for prices to recede. As the graph shows, year-over-year price increases are in double-digits for many food items and well over 2% for expenses that most families experience.

If the Fed wants to continue with a wait-it-out strategy the messaging just got a lot harder. Public and political pressure will increase with the idea that they have to be seen as doing something. That something is most likely an acceleration of tapering so as to get to rate hikes quicker.

Also complicating the Fed’s decision process is the still uncertain fate of Powell as chairman. His term expires in February and no word has come down from President Biden on retaining Powell or moving to Lael Brainard. Changing leadership in the midst of critical monetary policy decisions is a dicey proposition and one that will likely increase market volatility if Biden opts for a change.  Meanwhile, the market is increasing odds of rate hikes next year and that is a topic we explore in more detail in the next section.


Fed Funds Futures Move to New Highs After October CPI

While the Fed have been preaching patience in regards to what it believes to be transitory inflation forces, the market has moved forward with rate hiking expectations in the wake of the October CPI report.  The graph below tracks the fed funds futures market for December 2022 and you can see the October CPI numbers sent futures to a new high, but interestingly it’s not too far above the previous high set just before the November FOMC Meeting. Recall in that meeting Fed Chair Powell stressed patience and the market seemed to buy into the transitory message as futures receded from the 90 bps level.

Source: Bloomberg

The CPI report, however, removed all of those post-FOMC meeting good feelings about inflation with the futures rate moving to a new high of 94bps, implying nearly three rate hikes in 2022. Recall the Fed’s September forecast found them evenly split on a single rate hike in 2022 with two more in 2023. Needless to say, the December 15 FOMC meeting, with refreshed rate and economic forecasts, will be the key market event in December.

It seems likely they will unequivocally pull forward at least one rate hike into 2022, if not two. As we mentioned in the previous section, the Fed will feel increasing pressure to be seen as doing something and forecasting rate hikes in 2022 seems a likely and obvious choice.

 


Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.42 0.81 1.08 1.40 1.98 2.44
0.50 0.41 0.79 1.02 1.29 1.84 2.33
1.00 0.40 0.75 0.99 1.25 1.75 2.20
2.00 0.74 0.93 1.17 1.63 NA
3.00 1.12 1.57 NA
4.00 1.52 NA
5.00 1.48 NA
10.00 NA

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Published: 11/11/21 Author: Thomas R. Fitzgerald