U.S. Federal Reserve Board Chairman Jerome Powell speaks during his hearing on Senate Banking, Housing, and Urban Affairs Committee renominations on Capitol Hill in Washington, U.S., on January 11, 2022.
Graeme Jennings | Reuters
The Federal Reserve is expected to say this week that it is moving forward with interest rate hikes and considering further policy tightening, reversing easy policies it has put in place to fight the pandemic.
The Fed begins its two-day meeting on Tuesday and on Wednesday afternoon the central bank is expected to release a new statement that shows it is committed to tackling inflation. In the context of a violent stock market correction, Fed officials should say they are ready to raise the federal funds rate from zero as early as March.
“We don’t expect them to look dovish,” said Mark Cabana, head of US short rates strategy at Bank of America. “The [bond] The market seems to be reacting to falling stocks and geopolitical tensions, so perhaps the Fed doesn’t seem as hawkish as it otherwise would have. But we don’t think the Fed is going to tell the market it’s wrong to price in four rate hikes this year.”
The Fed found itself in its first major battle with inflation in decades, after two years of super-easy policies implemented to counter the economic and financial impact of the pandemic. The consumer price index in December rose 7%, the highest since 1982.
In this week’s statement, Cabana said the Fed could indicate that its first rate hike since 2018 could take place as soon as the next meeting, which would be in March. He made a similar comment in 2015, in the statement a month before his first rate hike after the financial crisis.
The stock market sell-off, if any, has made the Fed’s job more difficult. The S&P 500 plunged into correction territory on Monday down 10% from its record close, before a giant reversal in the intraday market. With the pandemic continuing and Russian military action looming against Ukraine as well, the Fed will have to recognize these risks.
“What they will have to do is say that we will react according to the conditions. We have to deal with inflation and even with what we see, the financial conditions are too loose. That is the only message that they can give at the moment,” said Diane Swonk, chief economist at Grant Thornton.
Powell will brief the media as usual after the Fed releases its 2 p.m. ET statement. Powell’s tone should also sound hawkish.
“I think he’s going to say every meeting is live, and we’re going to use every tool to fight inflation, which is still a problem even with the S&P 500 down 10%. It’s still up. 15% over last year,” Cabane said. “I don’t think they’re going to be scared off by this. They need to tighten financial conditions so they can better control inflation…I just don’t think the Fed is going to be surprised by this, I don’t I don’t think they’ll feel like the economy is going to fall off a cliff either.”
Further policy tightening
Fed officials also discussed shrinking their nearly $9 trillion balance sheet, which more than doubled during the pandemic. At their December meeting, central bank officials discussed the balance sheet, and some strategists expect the downturn to begin in June or even as early as May.
The central bank’s asset purchase program, which is due to end in March, has been a major contributor to the size of the balance sheet. The Fed had been buying $120 billion worth of Treasuries and mortgage-backed securities a month, but dwindled.
Once this program is over, Fed officials should start looking at how they will reduce the balance sheet. The Fed is currently replacing maturing securities with market purchases. He could modify this transaction and take other measures, such as changing the duration of the securities he holds.
“The fact that they’re talking about reducing the balance sheet at the same time that they’re still adding to it is a bit inconsistent,” Swonk said. Because of this, she expects there will be some dissent at this week’s meeting, and at least one Fed member, like St. Louis Fed President James Bullard, could pressure to end purchases immediately.
Swonk said there is also debate within the Fed about how aggressively with rate hikes. Some market pros have speculated that the Fed could get out of the gate quickly with a half-percentage-point rate hike in March, although the consensus is for a quarter-point hike.
By changing the balance sheet at the same time as it raises rates, the Fed would accelerate the pace of tightening. Swonk said every $500 billion on the balance sheet was worth 25 basis points of tightening. “They’re talking about cutting it by $100 billion a month. They could easily go faster,” she said.
Market reaction
Cabana said he expects 70% to 80% of the stock sale to be due to the Fed’s move toward tighter policy. He said he spoke with investors, who were very surprised that the Fed is considering reducing the balance sheet.
“That was telling me. This is a market that was addicted to the Fed ‘put’ and the belief that the Fed is always backing you,” he said. “The idea that the Fed could damage the market was unfathomable.”
Barry Knapp, head of research at Ironsides Macroeconomics, said the stock market’s decline was not a surprise and that the S&P 500’s 11% drop on Monday was consistent with the average drop after other tightening measures. the Fed.
Starting with the end of the first quantitative easing program after the financial crisis, he said there were eight cases between 2010 and 2018, all with an average decline of 11%.
“We should stabilize here. I don’t think there’s much Jerome Powell can say here that’s going to make it worse. Starting to reduce the balance sheet is under consideration. All the real doves said we We have to start. Inflation is now a problem,” he said. “The market will stabilize because the growth outlook is not deteriorating.”
Knapp said one of the most worrisome components of inflation is rent and housing costs, which are expected to rise. He said if the Fed decided to eliminate mortgage-backed securities from its balance sheet, it would help slow inflation in general.
“If they want to tighten financial conditions, they want to slow inflation, the biggest contributor to inflation in 2022 will be housing inflation,” he said. “Property prices will go down, supply chains will thin out. But this increase in house prices and rents is going to keep going up. It’s already above 4%. The main channel of the Fed to slow inflation in this case is via the housing market.”
