With high inflation pressing consumers and businesses, the Fed is expected to signal that it will raise its benchmark short-term interest rate in March in a dramatic reversal of the ultra-low rate policies it imposed during the pandemic recession. To further tighten credit, the Fed also plans to end its monthly bond purchases in March. And later this year, it could begin to reduce its huge stockpile of Treasuries and mortgage bonds.
Investors fear there is more to come. Some on Wall Street fear that on Wednesday the Fed will signal an upcoming half-point hike in its key rate. There are also fears that during a press conference, Fed Chairman Jerome Powell could suggest that the central bank will hike rates more times this year than the four hikes predicted by most economists.
Another wild card – especially for Wall Street – is the Fed’s bond holdings. As recently as September, those holdings were growing by $120 billion a month. The bond purchases, which the Fed financed by creating money, were aimed at cutting longer-term rates to stimulate borrowing and spending. Many investors saw buying bonds as helping to fuel stock market gains by injecting liquidity into the financial system.
Earlier this month, the minutes of the Fed’s December meeting revealed that the central bank was considering reducing its bond holdings by not replacing maturing bonds – a more aggressive step than simply ending to purchases. Analysts now predict that the Fed could start cutting its stake as early as July, much earlier than expected just a few months ago.
The impact of the reduction in the Fed’s bond stock is not well known. But the last time the Fed raised rates and cut its balance sheet simultaneously was in 2018. The S&P 500 stock index fell 20% in three months.
If, as expected, the Fed raised its key rate in March by a quarter point, it would take it to a range of 0.25% to 0.5%, up from near zero. The Fed’s actions risk making a wide range of borrowing more expensive – from mortgages and credit cards to auto loans and business credit. These higher borrowing costs could in turn slow spending and weaken corporate profits. The most serious risk is that the Fed’s abandonment of low rates, which have fueled the economy and financial markets for years, could trigger another recession.
These concerns caused stock prices to fluctuate wildly. The Dow Jones average plunged more than 1,000 points in Monday’s trading session before recovering and ending with a modest gain. On Tuesday, the S&P 500 closed down 1.2%. Steady year-to-date declines have left the S&P down nearly 10%, the level investors define as a “correction.”
Economists have predicted that when the Fed begins to allow some of its $8.8 trillion in bonds to roll off its balance sheet, it will do so at a rate of $100 billion a month. By not replacing certain securities, the Fed is actually reducing demand for Treasuries. This increases their returns and makes borrowing more expensive.
Still, some analysts say they aren’t sure how big the impact will be on interest rates or how much the Fed will rely on shrinking its balance sheet to affect interest rates.
“There is some uncertainty about what to expect,” said Michael Hanson, global economist at JPMorgan Chase.
Gennadiy Goldberg, US rates strategist at TD Securities, said Wall Street was also taken aback by the sharp rise in the inflation-adjusted interest rate on the 10-year Treasury. That rate jumped half a percentage point this month, an unusually fast rise.
All of this means Powell will face a tricky and even risky balancing act at his press conference on Wednesday.
“It’s a story of threading the needle,” Goldberg said. “They want to continue to appear hawkish – but not to the point of creating extreme market volatility.”
If the stock market is engulfed in more chaotic declines, economists say, the Fed could decide to delay some of its credit tightening plans. However, modest stock price declines are unlikely to affect its plans.
“The Fed doesn’t mind seeing a repricing of risk here at all, but would like to see it in an orderly fashion,” said Ellen Gaske, chief economist at PGIM Fixed Income, a global asset manager.
Some economists have expressed concern that the Fed is already acting too late to tackle high inflation. Others say they fear the Fed is acting too aggressively. They argue that many rate hikes would risk provoking a recession and would in no way slow inflation. From this perspective, high prices primarily reflect tangled supply chains that Fed rate hikes are powerless to remedy.
This week’s Fed meeting is taking place against the backdrop of not only high inflation – consumer prices have jumped 7% in the past year, the fastest pace in nearly four decades – but also of an economy plagued by a new wave of COVID-19 infections.
Powell acknowledged that he had not anticipated the persistence of high inflation, having long expressed the belief that it would be temporary. The spike in inflation has spread to areas beyond those hit by supply shortages – to apartment rents, for example – suggesting it could linger even after the goods and coins move more freely.
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