Here’s what to watch as the Fed prepares to hike rates and shrink its balance sheet
Anxiety is high as the Federal Reserve wraps up its first meeting of the year. Will the central bank abruptly end its emergency bond buying program sooner than expected? Are there more rate increases in store, and bigger increases at that? What tone will Chairman Jerome Powell take and what will those responsible for so-called quantitative tightening or balance sheet contraction say?
These are just a few questions swirling in financial markets, with differing views among economists and strategists reflecting growing monetary policy uncertainty as quantitative easing – massive monthly bond purchases – take hold. ends, rate hikes are approaching, and the Fed’s balance sheet is almost 40% of the United States. gross domestic product. This is when inflation is at its highest level in 40 years and Omicron is injecting further uncertainty into the economic outlook.
“This is a major risk event for the market, and the Fed will need to follow the meeting with carefully crafted rhetoric to define what it is doing, explain it to the public, and set a direction at a time. gradual and orderly during a time of rising inflation risk,” says Joe Brusuelas, chief economist at RSM.
With that, here’s a look at what to watch for as the Fed’s policy arm, the Federal Open Market Committee, releases its policy statement at 2 p.m. EST and Powell takes questions from the media. at 2:30 p.m.
First of all, will there be a surprise action?
Don’t count on it, says Roberto Perli, head of global policy at Cornerstone Macro. He doesn’t think the FOMC will take any concrete action, such as stopping QE early (it should end in March) or raising interest rates. On the contrary, says Perli, the Fed will use this meeting to make future decisions and prepare the market for it. That means the telegraph of interest rate takeoff is likely in March, barring any negative economic data surprises, Perli says. It won’t be a surprise. Markets have almost fully priced in a 0.25% rate hike to be announced at the Fed’s mid-March meeting, according to CME’s FedWatch tool.
Could Powell signal a bigger-than-expected rate hike in March?
Sure, and Powell will want to stay flexible, but at this point he seems unlikely to warn that anything more than a 0.25% rate hike is coming. The odds of a 0.50% increase are growing, but not yet close to baseline territory, Perli says.
The last time the Fed rose more than 0.25% all at once was in May 2000. Perli notes that inflation is now much higher than it has been over the past two decades, which means that the precedent is not binding. “We still think the FOMC will prefer to be gradual and predictable (i.e. move in 0.25% increments), but ultimately it will be the inflation data that will decide the pace of tightening,” Perli said.
Any hint from Powell that the FOMC might raise rates more than 0.25% would come as a big surprise; markets are only placing about a 6% chance of a half-point hike in March, according to CME data.
What about the possibility of more frequent rate increases than expected?
The FOMC holds eight meetings a year and updates its economic and interest rate projections quarterly (March, June, September and December). Perli reminds investors that during the 2015-2018 tightening cycle, the Fed only raised rates at meetings associated with new forecasts, so at most four times a year.
This time is different, given the inflation situation. Powell will likely want to retain some flexibility on the timing of the rate hike, which means every meeting from March onwards is “live.” But at the same time, Perli says, Powell is unlikely to go out of his way at this point to try to alter market expectations for four raises this year and up to three next year.
What will the Fed say about its balance sheet projects?
Earlier this month, the Fed spooked investors when minutes from its December meeting (released Jan. 5) showed officials had begun discussing plans to shrink its balance sheet. Specifically, officials signaled that QT, or QE reversal, would begin much earlier and proceed much faster than last time (2017-19). Some Fed members have since seemed surprisingly hawkish on the subject, such as Atlanta Fed President Rapael Bostic when he suggested the Fed could let its holdings drop by at least $100 billion a month. to quickly withdraw some $1.5 trillion from the financial markets.
Canceling at least part of the massive emergency bond-buying program is itself a form of tightening that some economists say will have more impact than rate hikes, the primary policy tool of the Fed. Many economists say the central bank likely still has a lot of work to do on the details, but Powell knows the markets are crying out for more clarity. Perli expects QT to start just one to two quarters after liftoff and run on a cap system about twice as large as last time. While the FOMC likely won’t finalize its plans for the stocktake at this meeting, Powell is expected to reveal a few more details that could cement expectations for a quicker and faster quantitative tightening process, Perli said.
Some economists doubt that Powell offers much clarity on QT today, not necessarily because it is lacking, but because of market turmoil. Even though members have agreed to a plan to liquidate the balance sheet, Powell won’t say anything about it, says Pantheon Macroeconomics chief economist Ian Shepherdson. “The Fed is not there to throw gasoline on a fire,” he said, adding that the combination of deep economic uncertainty over Omicron’s balance sheet and the sudden increase in market volatility means that now is not the time for the Fed to scare off investors. Even further.
Speaking of market volatility, will this influence the Fed?
Many economists and strategists say the Fed’s so-called put – the idea that the central bank will save investors from severe downturns – is virtually dead given high inflation. That’s not the case, says George Goncalves, head of US macro strategy at MUFG’s institutional client group.
“We don’t subscribe to the mainstream view that the FOMC will completely ignore what’s happened in the markets,” Goncalves said. “The United States is a highly financialized economy, driven by low rates and now high stock markets,” he says, predicting the Fed will look “balanced” coming out of the latest meeting to avoid further de-risking. before the March meeting.
The idea, Goncalves says, is that as long as stocks find stability and avoid sinking deep into a sustained bear market in the first half of the year, the Fed will tighten as much as possible and then pause. , taking the time to assess financial conditions, inflation and avoid jumping into a slowing economy ahead of the midterm elections.
Pantheon Macroeconomics’ Shepherdson expects Powell to say the Fed isn’t targeting any specific level of asset prices, while pointing out that deep and sustained declines in stock and bond prices can trickle down to slowing growth. . It’s a chicken-and-egg story, he says: If stocks fall because investors fear aggressive Fed tightening, the Fed could downgrade its economic forecasts to the point of believing that tightening much less is needed. Asset markets then breathe a sigh of relief and rebound, until the recovery is strong enough for the Fed to again signal its intention to tighten further.
Shepherdson says this dance could continue in an economy with near-trend growth and stable, low inflation with policy not far from neutral. But that’s not what we have. The policy is so loose that the real, or inflation-adjusted, federal funds rate would still be just above -2%, even if inflation expectations were stuck on target (they are well on target). above), which means the FOMC must start raising rates unless the stock market correction becomes a rout that destroys the economy, he says.
Write to Lisa Beilfuss at [email protected]