FOMC Minutes Preview: Data Dependency Is The Disaster-In-Making

The Fed is set to release the minutes from its’ February 1st meeting on Thursday, and the market will be looking for clues about its future monetary policy. Specifically, given the recent strength in the labor market, and the plateauing inflation readings, the market questions whether the Fed could accelerate the interest rate hikes in March to 50bpt.

The FOMC February 1st official statement

First, let’s evaluate the official statement after the FOMC meeting on February 1st. In this meeting, the FOMC decided to increase the Federal Funds rate by 25bpt, which was the decrease in the pace of hikes from 50bpt:

The Committee decided to raise the target range for the federal funds rate to 4-1/2 to 4-3/4 percent.

But, more importantly, the FOMC was supposed to signal the end of hiking campaign, or the pause, at the May 2-3 meeting, after hiking by another 25bpt in March, and another 25bpt in May, which would bring the terminal rate right at the 5.1% level penciled in by the Fed as the expected terminal rate.

More dovish market participants even expected the Fed to pause in March at the terminal rate at 4.85%, referencing the October and November data showing inflation falling faster than expected.

However, the FOMC decided to keep open the possibility of “ongoing” interest rate hikes (emphasis added):

The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

The decision to keep the “ongoing” term in the official statement is hawkish, as it implies, in my opinion, at least 3 more hikes, which would include the hike in June above the Fed’s 5.1% projected target to 5.35% terminal rate.

Further, the FOMC reveals that the monetary policy decision making is data dependent.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook.

So, the key takeaway from the FOMC official statement is that projected interest rates hikes are ongoing (no explicit signal for pause), however, the dovish data can essentially end the hiking cycle even in March – which is data-dependently dovish. This message caused the massive January rally in stocks, weakening US dollar, and falling interest rates, supported with the expected continuation of the “dovish” readings on inflation and growth from Q4 of 2022.

The post-meeting press conference

After the FOMC meeting, the Fed Chair holds a press conference to explain the FOMC decision and to answer the questions from the media, and this is important because sometimes the Fed Chairs revels the broader FOMC discussion, beyond the official statement.

At the February 1st press conference, the Fed Chair Powell repeated the key points from the statement – which was basically hawkish given the projected “ongoing” interest rate hikes.

However, the sentiment was overwhelmingly dovish, as Powell disproportionately focused on “the disinflationary theme” without the increase in the unemployment rate, which was clearly based on Q4 2022 weaker growth data and faster-than-expected fall in inflation.

So I would say it is a good thing that the disinflation that we have seen so far has not come at the expense of a weaker labor market.

The key takeaway from the press conference is that the Fed seems confident that the peak inflation has been reached, the disinflationary process has begun, while the economy is still holding up well. Powell did not seem to be worried about the rising stock market and general loosening of the financial conditions either.

The FOMC minutes – how the decision is made

The Fed releases the FOMC minutes to the public about 3 weeks after the meeting. These minutes illustrate how the FOMC makes the decision and provides clues about the key variables that shape the expected monetary policy.

Based on December 2022 FOMC minutes, it appears that the FOMC starts the meeting with the discussion of the Developments in Financial Markets, evaluating the cross-asset performance (stock, bonds, currencies, commodities). The FOMC pays close attention to the inflation expectations of TIPS.

Next, the Fed moves to the Staff Review of the Economic Situation, where the FOMC discuss the economic data, with the focus on growth inflation, and unemployment.

Subsequently, the FOMC moves to the Staff Review of the Financial Situation, with the focus on the market expectations for the Federal Funds rate, and the general credit conditions.

Finally, before the Committee Policy Action, the FOMC moves to the Staff Economic Outlook, based on the discussion from the previous sections. In selected meetings, the FOMC published the Participants’ Views on Current Conditions and the Economic Outlook, although it’s likely that individual members of FOMC voice their views in all meetings.

So, what to expect from the January FOMC meeting minutes?

• Obviously, the Fed will acknowledge the strong stock market performance in January, and the broader loosening of financial conditions. However, I don’t expect the FOMC to explicitly see this as a barrier to the monetary policy target of 2% inflation.
• The FOMC is still likely to be encouraged by the positive inflation data from December 2022, which would fit in the narrative of disinflation.
• The FOMC will also acknowledge the weakening labor market in November and December, as the number of temporary workers decreased, and the number of average hours worked decreased – both being the leading indicators.
• The FOMC will also acknowledge the decrease in consumption and industrial production from Q4 2022.
• Broadly, the FOMC will be acknowledge the perfect scenario of disinflation, slightly weakening labor market, and modestly slowing growth – the soft landing.

And then the Fed got slapped in the face

At the same day as the FOMC decision day, the labor report showed 517K of new jobs created, and the unemployment rate falling to 3.4%.

Subsequently, all inflation readings were higher than expected, and most economic growth data also higher than expected.

If the FOMC was really looking at the “historical data” the make the decision, it completely missed the outlook.

It’s obvious to anybody with a minimum economics training that the current environment is structurally inflationary.

• The labor shortage is function of aging demographics and restrictive immigration policies, and this is inflationary.
• The supply-chains remain vulnerable due to issues with China and energy prices continue to be vulnerable to spikes due to long-term issues with Russia – this is also inflationary.
• Anybody who traveled during the holidays witnessed all flights full, the US is actually finally fully reopening post-covid. I was in Las Vegas for New Years, and it hit me when the local news said that they expect 400K people to celebrate New Years, since that was the first post-covid public celebration. That would explain the January strength, if it happened nationally.
• And yes, China is fully reopening.

The FOMC likely missed all this and focused on softish Q4 numbers, and prematurely declared the victory on inflation.

Implications for investors

Investors who got back into the stock market based on the Fed’s “disinflation” narrative also got “slapped in the face.” The bear market in S&P500 (SP500) rally peaked on February 2nd, as the market repriced the “soft-landing” scenario with something much more serious.

It’s obvious now that the Fed will turn more hawkish, which is not going to be reflected in the FOMC minutes on Thursday, because the Fed is data-dependent.

The higher the Fed is “forced to go” now, the higher the probability of a much deeper and longer recession, which puts the S&P500 at the risk of a very deep drawdown (my target is 2800).