Anxiety is high as the Federal Reserve wraps its first meeting of the year. Will the central bank abruptly end its emergency bond-buying program ahead of schedule? Are more rate increases in store, and bigger increments at that? What tone will Chairman Jerome Powell strike, and what will officials say about so-called quantitative tightening, or balance-sheet shrinkage?
Those are just a few questions swirling around financial markets, with differing views among economists and strategists reflecting rising monetary policy uncertainty as quantitative easing—the massive monthly bond buys—winds down, rate increases approach and the Fed’s balance sheet represents nearly 40% of U.S. gross domestic product. That’s as inflation sits at a 40-year high and Omicron injects new uncertainty over the economic outlook.
“This is a major risk event for the market, and the Fed will need to follow up the meeting with carefully crafted rhetoric to define what they are doing, explain it to the public and lay out a direction that is both gradual and orderly during a time when the risk from inflation is rising,” says Joe Brusuelas, chief economist at RSM.
With that, here’s a rundown of what to watch for when the Fed’s policy-setting arm, the Federal Open Market Committee, releases its policy statement at 2 p.m. Eastern time and Powell takes media questions at 2:30.
First, will there be any 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, like stopping QE early (it’s set to end in March) or raising interest rates. Rather, Perli says, the Fed will use this meeting to set up future decisions and prepare the market for them. That means telegraphing interest-rate liftoff is likely in March, barring negative economic data surprises, says Perli. That will come as no surprise. Markets have almost fully priced in a 0.25% rate increase to be announced at the Fed’s mid-March meeting, according to CME’s FedWatch tool.
Could Powell signal a bigger-than-anticipated rate increase in March?
Sure, and Powell will want to remain flexible, but at this point he seems unlikely to warn that something more than a 0.25% rate increase is coming. The odds of a 0.50% increase out the gate are going up but are not yet close to base-case territory, Perli says.
The last time the Fed hiked more than 0.25% in one shot was in May 2000. Perli notes that inflation now is much higher than it has been over the past couple of decades, meaning the precedent isn’t 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 tightening pace,” Perli says.
Any hint from Powell that the FOMC may lift rates by more than 0.25% would be a big surprise; markets are placing only about 6% chance of a half-point hike in March, CME data show.
How about the possibility of more frequent-than-expected rate increases?
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 in the 2015-18 tightening cycle, the Fed raised rates only at meetings associated with new forecasts—so at most four times a year.
This time is different, given the inflation situation. Powell is likely to want to maintain flexibility over rate hike timing, meaning every meeting from March onward is “live.” But at the same time, Perli says, Powell probably won’t go out of his way at this point to try to change market expectations for four increases this year and up to three next year.
What will the Fed say about its balance-sheet plans?
Earlier this month, the Fed spooked investors when its December meeting minutes (published Jan. 5) showed officials began discussing plans to shrink its balance sheet. Specifically, officials signaled QT, or the reversal of QE, would start much sooner and proceed much faster than last time (2017-19). Some Fed members have since sounded surprisingly hawkish on the topic, such as Atlanta Fed President Rapael Bostic when he suggested the Fed could let its holdings fall by at least $100 billion a month to quickly withdraw some $1.5 trillion out of financial markets.
Reversing at least part of the massive emergency bond-buying program is itself a form of tightening that some economists say will be more consequential than rate increases, the Fed’s primary policy tool. Many economists say the central bank likely still has a lot of work to do on details, but Powell knows markets are clamoring for more clarity. Perli expects QT to start just one to two quarters after liftoff and proceed according to a system of caps about twice as large as last time. While the FOMC probably won’t finalize its plans for the balance sheet at this meeting, Powell should reveal some more details that are likely to cement expectations of an earlier and faster quantitative tightening process, says Perli.
Some economists doubt Powell will today offer much clarity on QT—not necessarily because he lacks it, but because of market turmoil. Even if members have agreed to a balance-sheet runoff plan, Powell will say nothing of it, says Pantheon Macroeconomics chief economist Ian Shepherdson. “The Fed is not in the business of pouring gasoline on a fire,” he says, adding that the combination of deep economic uncertainty over Omicron’s toll alongside the sudden surge in market volatility means that this is not the time for the Fed to spook investors even further.
Speaking of market volatility, will it influence the Fed?
Many economists and strategists say the so-called Fed put—the idea that the central bank will rescue investors from serious downturns—is all but dead given how hot inflation is. Not so, says George Goncalves, head of U.S. macro strategy at MUFG’s institutional client group.
“We do not subscribe to the prevailing view that the FOMC will completely ignore what has been happening in markets,” says Goncalves. “The U.S. is a highly financialized economy levered to low rates and now high stock markets,” he says, predicting that the Fed will sound “balanced” coming out of the latest meeting to avoid causing further de-risking before the March meeting.
The idea, says Goncalves, is that so long as stocks find stability and avoid pushing deep into a sustained bear market in the first half of the year, the Fed will front-load as much tightening as possible and then pause, taking time to assess financial conditions, inflation and avoid hiking into a slowing economy before midterm elections.
Shepherdson at Pantheon Macroeconomics expects Powell to say that the Fed doesn’t target any specific level of asset prices while also nodding to the point that sustained, steep declines in stock and bond prices can feed back into slower growth. It’s a chicken-and-egg story, he says: If stocks are falling because investors fear aggressive Fed tightening, the Fed might mark down its economic forecasts to the point where they believe significantly less tightening is needed. Asset markets then breathe a sigh of relief and rebound, until the rally is strong enough for the Fed again to signal its intention to tighten further.
Shepherdson says this dance could continue in an economy with close-to-trend growth and stable, low inflation with policy not far from neutral. But that isn’t what we have. Policy is so loose that the real, or inflation-adjusted fed funds rate would still be barely above -2% even if inflation expectations were locked at the target (they’re well above), meaning that the FOMC must begin raising rates unless the stock market correction becomes an economy-wrecking rout, he says.
Write to Lisa Beilfuss at [email protected]
