Fed preview: End of money printing brrrrr – Four 25bp rate hikes this year and QT in September

Key takeaways

• At the upcoming January meeting, we expect the Fed to indicate that the first rate hike is likely in March if the economy develops in line with expectations, supported by the tight labour market and still very high inflation.

• It is one of the interim meetings without updated projections or dots.

• We have changed our Fed call now expecting four 25bp rate hikes this year (in March, June, September and December, up from three previously) and still four rate hikes in 2023. We expect the Fed to start reducing the balance sheet from September.

• Given the combination of a strong economy and high underlying inflation, we see risks as skewed towards more, not less, tightening. If this scenario plays out, the Fed is likely to hike 25bp at each meeting, not skipping interim meetings.

• Fixed Income: We have lifted our target to 2.25% for 10Y UST.

Fed under increasing pressure from tight labour market and high inflation

The December jobs report disappointed, as employment growth was just 199,000, well below consensus. Some are arguing that it means the Fed can stay more patient, all else equal, but we do not share that view and based on recent Fed speeches and interviews, it does not seem like consensus among FOMC members either. To us, it is a sign that the labour market is even tighter than what we thought. Employment growth is unlikely to pick-up until we see a more significant rebound in labour force participation. And if the labour force starts to pick, higher employment growth would most likely still be a signal that the labour market is tightening, as labour demand is very high.

CPI inflation reached 7.0% y/y in December 2021, the highest since June 1982. CPI core inflation is 5.5% y/y, both way above the 2% target. Short-term inflation expectations are still elevated and long-term inflation expectations in the University of Michigan consumer confidence survey is now 3.1% y/y, the highest since 2011. Many small businesses report they expect to hike output prices. The trend is that economists, like ourselves, underestimate the underlying price increases and hence we think it is more likely that inflation will be higher, not lower, than we forecast.

Therefore, we are changing our Fed call. We now expect the Fed to start the hiking cycle in March (from May previously) and to hike a total of four times this year (March, June, September and December) and four times in 2023. A March hike also seems likely when listening to recent comments from several FOMC members in January. Given the tight labour market and high inflation, we think risks are skewed towards more tightening, not less. Based on Fed’s Christopher Waller’s recent comments, it seems unlikely that the Fed is going to hike 50bp, but instead the Fed may hike 25bp at every meeting instead of skipping interim meetings like we got used to during the latest hiking cycle. We discuss further later in the piece.

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