Morgan Stanley: As Uncomfortable As It Can Be To Admit Defeat, Here We Are

By Seth Carpenter, global chief economist at Morgan Stanley

This past week, our US economics team revised its Fed call. The change is motivated by the notable shift in rhetoric from Chair Powell. I want to walk through some of the logic, some of the implications, and why we have not seen a second “taper tantrum.”

In November, the taper was announced. Since then, inflation prints have evidently surprised the Fed to the upside, and the public debate about inflation has reached fever pitch. A subtle, but to me particularly telling cue, was Chair Powell asserting that price stability is now the path to full employment. Waiting until 2Q or 3Q for inflation to fall is off the table. Now the level, not just the trajectory of inflation, is key…and the Fed is set to accelerate the taper.

A change in the reaction function means a change in our call. Of course, the market has been there for some time, and as uncomfortable as it can be to admit defeat, here we are. So what next?

In my time at the Fed, policy decisions were taken one step at a time. The faster taper – as Cleveland Fed President Mester noted –simply provides optionality, it does not commit the FOMC to a hike when it is done. In March, I suspect Chair Powell and team will want to pause to assess the markets and the economy. If our inflation call is right, they will have to wrestle with monthly inflation prints that are coming down faster than forecast.

Falling inflation should reduce, but not eliminate, the urgency to raise rates. Some persistence in trend inflation will remain, so we are looking for quarterly rate hikes, starting in September. Next, the question will be when to unwind the balance sheet. I was a debate participant inside the Fed during the last cycle. The winning argument was to start with rates because the Fed had experience with that tool but not with the balance sheet. One cycle using the new tool probably does not change the sequencing. Consider that the FOMC reversed course on rates in early 2019 while shrinking the balance sheet; tightening had gone too far, too fast. And in September that year, just months later, the Fed had to rebuild reserves after over-shrinking. A single cycle’s worth of experience does not look like enough. Of course, now there is further to go, so the unwind may start a bit lower than the 1.25% level last time, but I suspect the playbook is largely unchanged.

Does a sea change at the Fed mean a tsunami for the rest of the world? In 2013, the 10-year yield troughed at 1.63% but ended the year a touch over 3%. Partly by design and partly by circumstance, we are in a different place today. Once bitten, twice shy: the Fed worked hard to avoid a taper tantrum this time. The foreshadowing started way back in the minutes of the September 2020 meeting.

Markets have started to price in Fed hikes, but yields have moved nothing like they did in 2013. Global inflation has already put many EM central banks on a hiking path; instead of being caught off guard, most have stayed ahead of the curve [ZH; just ignore China which is already in easing mode]. And even with the market pricing rate hikes, real US rates look likely to pick up only gradually. This time really does seem to be different.