Fed Using Scare Tactics to Control Inflation Expectations
The author is an analyst of NH Investment & Securities. He can be reached at sw.kang@nhqv.com. -- Ed.
At the December FOMC, the Fed is likely to turn more hawkish and raise its 2022 growth forecast. The Fed’s anticipated tightening signal is to be aimed at controlling inflation expectations. Economic growth expectations should persist. We predict that BEI downtrend and real yield recovery will continue.
Fed using scare tactics to control inflation expectations
At the upcoming December FOMC, an acceleration of tapering (previously mentioned by Chair Powell) is to be announced along with a move forward in the end of tapering from June to March of 2022. We expect the dot plot to display a higher median FF rate for 2022 and at least one rate hike in 2022. Of note, the 2024 FF rate forecast, which has a significant impact on 10yr US TB yield, is also projected to rise significantly.
Of key importance will be how long-term US TB yields interpret and respond to a more hawkish Fed. On Nov 10, when October CPI was announced, 2022 rate hike probabilities, as reflected in forward yields, spiked upward. We note that the market implied 2022 FF rate shot up by 25bp immediately after the October CPI announcement, whereas 10yr TB yield climbed by only 4.8bp.
Long-term TB yields are formed of: 1) base rate forecasts; 2) growth expectations; 3) inflation expectations; and 4) other factors. A multicollinearity problem arises, as base rate forecasts are strongly correlated with both growth and inflation expectations. In other words, when FF rate hike expectations increase, the TB market adjusts both growth and inflation expectations at the same time. Since concerns over early tightening by the Fed have become highlighted, BEI (a proxy for inflation expectations) has fallen by 16.2bp, and real 10yr TB yield (a proxy for growth expectations) has widened by 21bp. We view this development as reflecting the market’s trust in the Fed’s ability to control inflation without hampering growth.
Believing that the Fed’s current strategy represents the use of scare tactics to control inflation expectations, we expect that this form of tightening will be used only to the extent that it does not undermine the economy. Of note, at the December meeting, the Fed will likely unveil an improvement in growth forecast for 2022, leading to a lower BEI and higher real yields. Once inflation expectations decline sufficiently, nominal yields should begin their ascent.
Message from BOK Vice President: BOK thinking in line with market expectations
Behind the KTB market yield tantrum of October was the fear that the benchmark rate could climb to 1.75% in 2022. Last week, however, the BOK Vice President stated that ‘the market’s expectations for monetary policy are not much different from the BOK’s judgment’. As the KTB market’s 2022 benchmark rate consensus stands at 1.50% (vs our estimate of 1.25%), it appears that the BOK has successfully stepped back from its aggressive rate hike messaging.