What This Fed Watcher Is On The Lookout For | Colby Smith (February 2023 FOMC)

Episode Summary

Executive Summary: Colby Smith argued the Fed will likely hike 25 bps at the upcoming meeting, but the real focus is whether Powell signals the endgame: how far rates still need to rise, whether the statement changes, and how aggressively the Fed pushes back against easing financial conditions. Markets are pricing cuts too soon, while the Fed remains focused on inflation, labor-market resilience, and preserving restrictive conditions.

Main Topics: Expected February Fed rate hike (Priority: 5/5): Smith expects a widely telegraphed 25-basis-point increase and says the bigger question is the future path of hikes and whether the Fed is nearing a terminal rate above 5%. FOMC statement language and forward guidance (Priority: 5/5): The discussion centered on whether the Fed will remove or alter the phrase 'ongoing increases' and possibly replace it with language about holding rates restrictive for some time, to avoid signaling a premature pause. Markets versus Fed expectations (Priority: 5/5): A major theme was the disconnect between Fed officials, who expect no cuts in 2023, and financial markets, which are pricing cuts later this year and into 2024, easing financial conditions the Fed does not want. Financial conditions as a policy transmission channel (Priority: 4/5): Smith stressed that the Fed watches credit spreads, equities, mortgage rates, and the dollar because easier financial conditions weaken monetary restraint and can undermine inflation progress. Inflation data, core services, and wages (Priority: 4/5): Headline inflation has improved, but the Fed is more concerned with core services ex-housing and labor-market-linked wage pressures, which remain too sticky to justify a pivot. Fed communication strategy and 'live' meetings (Priority: 3/5): The conversation explained how the Fed uses statements, press conferences, speeches, the SEP, and media coverage to guide expectations, while avoiding overly specific forward guidance after getting burned in 2022. Debt ceiling and balance sheet/QT risks (Priority: 3/5): The interview closed with concerns that a debt-ceiling standoff or major market stress could complicate quantitative tightening and potentially force policy adjustments later in the year.

Key Arguments: The Fed is likely to keep hiking in 25-basis-point increments, but the key issue is whether it changes statement language to avoid promising endless 'ongoing increases.' Changing guidance too early could loosen financial conditions further; leaving the language unchanged could make the statement seem stale after substantial disinflation progress. The December dot plot showed most officials expected rates above 5%, and intermeeting speeches did not materially shift that view. Financial conditions matter because easing in stocks, credit spreads, and mortgage rates can blunt the Fed's effort to tighten demand. Market pricing of cuts reflects either belief in a looming recession or a more optimistic inflation outlook than the Fed has; the Fed rejects both narratives. The Fed is more worried about under-tightening than over-tightening; Powell has implied it can cut later if needed, but cannot easily reverse an inflation spiral. Labor-market indicators are central because persistent services inflation is tied to employment strength and wage growth. QT is important but secondary to the policy rate; if cuts begin, the Fed may need to reconsider balance-sheet reduction so its tools are aligned. A debt-ceiling crisis could disrupt Treasury markets and potentially force Fed or Treasury responses, but neither wants to create a public contingency plan that reduces urgency to strike a deal.

Data Points: Fed funds target upper bound before meeting: 4.50% - Upper end of the target range prior to the expected 25-basis-point hike Expected hike at meeting: 25 basis points - Widely expected increase at the February FOMC meeting Projected upper bound after hike: 4.75% - Result if the Fed delivers the anticipated quarter-point increase Possible next hike in March: 5.00% upper bound - Would follow if the statement still signals ongoing increases Potential June range mentioned: 5.00%-5.25% - Where some dots/forecasts implied rates could go if tightening continues Dot plot participants above 5%: 17 of 19 officials - December SEP showing broad support for rates topping 5% Dot plot participants below 5%: 2 of 19 officials - Only a small minority expected a lower terminal rate Market pricing for terminal rate: Below 5% - Fed funds futures implied a lower peak than Fed officials forecast Market pricing for 2023 cuts: 50 bps of cuts by year-end 2023 - Described as directly at odds with Fed officials Market pricing for 2024 cuts: Up to 7 cuts by end-2024 - Used to illustrate the gap between markets and Fed expectations Employment Cost Index: ~1.0% q/q annualized; just over 4% annual rate - Released on the day of the interview and treated as consistent with sticky labor costs Current unemployment rate: 3.5% - Used to argue the labor market is still too tight for the Fed to pivot Pain threshold mentioned by Waller: Around 5.0% unemployment - Suggested as the level where the Fed faces a more serious tradeoff Headline inflation peak reference: About 9.1% y/y - Cited as the inflation shock that pushed the Fed toward aggressive hikes Mortgage rates: About 1 percentage point lower than in the fall - Example of easing financial conditions the Fed does not want to see Reverse repo facility: Close to $3 trillion - Mentioned as parked cash but not a realistic source of funding for the government Reverse repo amount later referenced: $2 trillion - A rougher estimate used in the discussion of liquidity plumbing QT/extraordinary measures timeline: Treasury measures through June - Yellen's estimate for how long the Treasury can keep operating under the ceiling March 2022 to current rate move: From 0% to 4.5% upper bound - Illustrates the rapid pace of Fed tightening over the prior year

Pivotal Quotes: "the big speculation ahead of this meeting is what do they do with that language now that we're kind of nearing the end point" — Colby Smith: On the likely FOMC statement change and whether the Fed softens its rate-hike guidance "financial conditions reflect the policy restraint that the Fed is putting into place" — Colby Smith quoting Powell: Why the Fed cares so much about markets loosening before inflation is fully contained "we know how to kind of deal with a set of circumstances when we overdo it. We can just cut interest rates. It's a much more difficult situation for us to deal with if we... let inflation kind of get out of control" — Colby Smith quoting Powell: Explaining why the Fed is more willing to risk overtightening than under-tightening

Implications: Listeners should expect a hawkish quarter-point hike and a strong message that cuts are not imminent. Markets may need to reprice if Powell pushes back harder against easing financial conditions or if data keep inflation sticky.