Consumer prices rose 7.0% for 2021 according to the December CPI report released early this morning (core prices rose 5.5%). That is the highest rate in 40 years, all the way back to the Volker era. Fed Chair Powell has expressed concern that inflation may become “entrenched.” Via speeches, interviews, and Fed minutes released, the Fed committee members have laid out a path for 2022 and beyond. The December unemployment report at 3.9% indicated that there is a “labor shortage” according to Fed officials. This is very significant as it means that both the inflation and employment “test thresholds” have been met (the so called “dual mandate”).
The 10 year T barely moved today as the big CPI numbers are not expected to change policy assumptions that are “priced in”. The 10 year closed out 2021 at 1.51% before a big spike last week, sending the yield as high as 1.81% on Wednesday. This spike was attributable to markets being surprised by the release of Fed minutes indicating that balance sheet runoff, aka QT (Quantitative Tightening) may occur this year. This was a surprise to markets. The Fed had already telegraphed the first two stages of policy tightening: tapering bond purchases (set to end two months from now) and raising the Fed Funds rate. The general assumption was that the “runoff” of the Fed’s balance sheet would not occur until 2023. The knowledge that the Fed may be a net seller of MBS and Treasuries this year was a jolt. The act of selling bonds removes liquidity from the system and will put additional upward pressure on rates. The consensus amongst major bank economists and the future markets is the following: Bond purchases end in March, then 3 or 4 rate hikes this year (March, June, September, December). That will bring the Fed Funds rate to 1.00-1.25%. This is halfway to the Fed’s “terminal rate target” which is now 2.50%. Balance sheet run off may start as soon as September, but definitely by December. Stay tuned. By David R. Pascale, Jr. , Senior Vice President at George Smith Partners