Wednesday, June 22, 2022

The Fed reaction function - Where all the market action is focused



Many have discussed the Fed's reaction function in the form of a simple. The Taylor Rule is the most popular of these models, yet it has fallen out of favor over the last decade; nevertheless, there still needs to be an understanding of the Fed's reaction under different scenarios. This should be the objective of forward guidance. Fed forward guidance is often obtuse and hard to unpack. What is a "soft landing"? What is "data dependent"? What is "unconditional"? 

Money is only made on trades that differ from the consensus and are correct. The Fed reaction function and trade opportunities fall into three categories: the Fed's commitment to inflation fighting, the Fed commitment to full employment, and the Fed's commitment to maintaining market stability. The Fed is unlikely to be able to manage all three in a rising rate environment. 
  • The market has discounted increases in rates, so the trade is whether Fed will become more aggressive and realize market expectations or whether the Fed will be condition in its fight against inflation. Is the Fed willing to sustain multiple 75 bps increases?
  • The market is discounting a higher probability of a recession than the Fed. If these likelihoods are true, the question is whether the Fed will again move away from its current project path of rate increases. If unemployment moves to 4.5%, will it slow rate increases or cut rates?
  • Finally, there is the question of how much financial instability will the Fed allow before acting to stem. We are in a bear market. Will the Fed be willing to see a 40+% correction and still increase rates. Will the Fed increase rates even if there was a funding problem on Wall Street. The likelihood increases as rates increase. Will the Fed sustain rate increases if there are increased threats of financial instability?
Can traders see scenarios where the Fed will abandon its inflation fighting in response to other goals. This is the big trade for 2022 and it seems likely that there are reasonable scenarios for switching priorities. Jay Powell is not Paul Volcker. The bias is toward rate increase abandonment. 

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