Staying Hawkish may Become too Difficult and Costly for the Fed after the CPI Release

Home » Staying Hawkish may Become too Difficult and Costly for the Fed after the CPI Release

A softer-than-expected US CPI for November has made the job more difficult for the Fed, in the sense that it will be increasingly difficult to justify further rate hikes. Nevertheless, Powell is likely to try to convince markets today that the policy tightening will continue next year and there are good reasons for this. This should somewhat ease selling pressure in greenback however, a breakout to new lows should not be ruled out in case of a dovish surprise. The inflation report released yesterday showed that core inflation continued to decline in November and the size of decline beat market expectations. In annual terms, prices in the economy, excluding volatile products such as fuel, food, etc., rose by 6% against expectations of 6.1%. Headline inflation slowed down from 7.7% to 7.1% against expectations of 7.3%. In monthly terms, core inflation was 0.2%, while the forecast was 0.3%.The data triggered a new round of rumors that the Fed will finally bend to market expectations and outline clear contours of the tightening cycle and in particular, give a hint that the terminal rate will be reached in 2023. In addition, the market bets that the Fed will revise the Dot Plot, so that the median terminal level of interest rates (on reaching which the Fed will stop) will fall below 5%. However, Powell is likely to try to protest today. Risk-free market rates, as well as credit spreads, have been declining since mid-October, and cheaper borrowing costs could undermine the Fed's plans to control inflation due to the expansion of the money supply in the economy (key inflation driver in medium-term) on rising credit availability:To prevent credit easing, the Fed chief will likely try to play down the recent decline in price pressures, say that the battle against inflation is not yet won, and try to re-peg peak rate expectations at 5%. However, this is easier said than done.The Fed's belated reaction at the end of last year due to the belief that inflation is transient has been a valuable lesson, and the central bank may be biased towards overshooting rather than undershooting in the policy tightening. Also, the Fed’s tendency to stick to the idea that inflation persistence is underestimated is obvious. It is worth remembering that in the summer of 2021 and 2022, inflation really slowed down for several months, but then accelerated again, so the Fed may be cautious about signs of inflation easing in October and November:The cost of such a position is that Powell will have to balance the fine line between the risk of losing credibility (when investors may begin to be guided by their own inflation forecasts, and not believe the Fed) and the risks of being wrong again, faced with a new acceleration in inflation, after following the lead of market expectations.December turned out to be a difficult month for dollar bulls, firstly, due to seasonal pressure, and secondly, due to a new surprise in inflation, so downside risks remain significant today. However, it should be kept in mind that a possible hawkish outcome of the FOMC meeting may now be greatly underestimated, and therefore the market reaction to it may be even more significant, including a strong short squeeze in greenback market. An asymmetric market reaction to the FOMC decision is expected, as the market sold the dollar before the CPI report and sold it after it. Consequently, positioning may be short-overweighted, so an additional dollar decline in the form of a friendly Fed outcome may be shallow and short-lived, and conversely, a hawkish surprise may lead to significant strength.

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