“Behind the curve” Fed Plays Catch Up

Written on 23/03/2022 by Lukman Otunuga, Senior Research Analyst at FXTM

Recently, we’ve had a “melt-up” in commodities, and now it’s the turn of bond markets to experience a “meltdown”. This comes about due to a reacceleration this week in the rise in bond yields from more hawkish talk from Fed Chair Powell and other FOMC policymakers. The ground is most definitely being dug, prepared, and seeded for a more aggressive policy calibration in May and the rest of the year.

Across the central bank spectrum, officials are scrambling to regain control of the inflation picture and contain further damage to their policy credibility. The message is now crystal clear, none more so than from the world’s most important central bank. Inflation is higher and more persistent than expected and the risks are skewed to an ever greater rate of price rises. Of course, this is a major shift for the US Federal Reserve which had maintained a call that inflation was “transitory” for an unsuitably long time.

There are numerous policy implications now as the Fed plays catch up, as it is “behind the curve”. This is when a central bank is seen as not raising interest rates at a pace fast enough to keep up with inflation. So, rather than a smooth transition in the normalisation of monetary policy and the economy, a much faster tightening of policy is set to take place this year than the Fed would have had to do, with potential risks of overcompensation. This will amplify worries about how the economy and markets will cope with rising borrowing costs and prices.

We’ve heard from other Fed officials already this week after Chair Powell’s updated “forward guidance” put (interest rate) markets on red alert on Monday. He said that the central bank is prepared to raise rates by 50bp at its next meeting, which is double the usual 25bp increments.

These more hawkish intentions are drawing ever more support within the FOMC, as even more dovish leaning officials like San Francisco Fed President Daly stress the need to step up the pace of policy normalisation and are not ruling out bigger rate hikes at some point soon. A strong economy and unacceptably high inflation are building a consensus to frontload tightening and bring the policy rate to, or even above the neutral rate.

Money markets have reacted swiftly and are now fully pricing in 75bps of tightening in the next two meetings, which implies at least one 50bp increase. Two back-to-back 50bp hikes in May and June is now very possible as the message seems fairly unambiguous. Real yields, those adjusted for inflation, are driving the bond market moves with an implied policy rate of 2.25% at the end of this year and a terminal rate nearing 3%.

This environment should still favour the dollar, particularly against low yielding currencies and those more exposed to the Ukraine crisis. The former we are certainly seeing in USD/JPY which has made fresh six-year highs this week, with talk of 125 being the ultimate target. And yet, we should also be mindful of the potential for a policy mistake, with tightening coming after inflationary expectations have become de-anchored. This could result in higher prices and lower incomes which means a “soft landing” could turn out to be a mirage.

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