The Federal Reserve said Wednesday it would hold the line on short-term interest rates, with a view to raising them “soon,” and cut the rate on its asset purchases, halting them in early March.
“It is the committee’s view to increase the federal funds rate at the March meeting,” Chairman Jerome Powell said Wednesday afternoon at a press conference after a two-day policy-making meeting. days. That would mean the rate hike would come almost exactly two years to the day after the central bank cut rates to zero in response to the emergence of the fast-spreading coronavirus, which threatened to destabilize the entire financial system.
Fast forward to 2022 and the macroeconomic climate has changed dramatically: today, the biggest economic worry for many is the rapidly rising prices of food, fuel, housing and a host of other goods and services.
“It hasn’t improved. It’s probably gotten a little worse,” Powell said of his current outlook for inflation, compared to what he projected at the last meeting in December.
When conditions change quickly, it can leave the Fed playing catch-up — a position that gives Wall Street heartburn.
As expected, many of the questions Powell asked were about interest rates, which he said were going to be the “active tool” the Fed plans to use to rein in inflation.
According to the CME’s FedWatch tool, market participants are expecting a rate hike of a quarter of a percentage point (25 basis points) at the March meeting with a probability of almost 90%.
“I think there’s enough room to raise interest rates without threatening the labor market,” Powell said, a remark that prompted Wall Street to pare most of the gains it had made earlier. during the day.
In addition to interest rates — its best-known policy tool — the Fed has also maintained loose monetary policy over the past two years by buying billions of dollars in Treasuries and mortgage-backed bonds each month. , a process she began to slow down. The purchases have almost doubled the Fed’s balance sheet over the past two years, and Wall Street is also looking for Fed officials to indicate when and how quickly they will begin to reduce the amount of these holdings, either by dropping them as they ripen or by selling them.
“What took the market by surprise in December was the idea that they made quantitative tightening a short-term issue,” said Keith Buchanan, portfolio manager at Globalt Investments. “It introduced the idea of these simultaneous measures to the market, which set the stage for what we saw in January” – in particular, the dramatic market fluctuations and high volatility as traders tried to play on the financial impact of policymakers increasingly concerned that inflation will hamper economic growth in 2022.
The biggest key for the Fed is to show that it takes inflation seriously.
A slow trajectory generally corresponds to the Fed’s measured and deliberate pace of monetary policy adjustment. As an institution, the central bank tends to adopt a long process of communication before acting. But when conditions change quickly, it can leave the Fed playing catch-up — a heartburn-inducing stance on Wall Street and one of the culprits market watchers blame for the wild gyrations that major indices have suffered in recent days.
“Historically, the Fed is really looking to calm the markets … but calming the markets after such an intense bout of volatility is going to be difficult,” said David Norris, partner and head of US credit at TwentyFour Asset Management.
The Fed realized — too late, Norris said — that the price inflation plaguing American businesses and consumers was both broader and longer lasting than it had anticipated.
“I would have liked to see the Fed announce the end of quantitative easing in the last quarter, as well as start raising rates, just because they are so far behind the curve and far enough from neutral,” Norris said. . noted.
Questions have also been asked about the timing and pace of the balance sheet reduction. Powell said policymakers hadn’t made a decision on those two factors, though he acknowledged that, at nearly $9 trillion, Fed holdings would most likely be subject to a “substantial decline.” “.
Mona Mahajan, senior investment strategist at Edward Jones, said shrinking the Fed’s balance sheet would help eliminate those distortions. “By removing liquidity from the system, where we’ve really seen that gambling in the markets gives less air to the most speculative and highly valued segments of the market,” she said.
Even without the pandemic in the mix, the Fed has a tricky balancing act. “There are a lot of other moving parts that come into the discussion,” said Charlie Ripley, vice president of portfolio management for Allianz Investment Management. “Higher wages could continue to make inflation more persistent in 2022.”
Markets today need reassurance that the Fed can and will target inflation, lest it escalate further. “The big key for them is to say they take this seriously,” said Lawrence Gillum, fixed income strategist at LPL Financial.
Powell acknowledged the challenges for the central bank, saying policymakers must navigate cross-currents and what he called “bilateral risks” — inflation on one side, the pandemic on the other. He also noted the rush of the pandemic through China, a country largely devoid of immunity to the highly contagious omicron variant of the coronavirus. He said China’s zero Covid policy “could play into more problems in supply chains” as the government forces the closure of factories and ports.
The pandemic has destroyed some 22 million jobs, triggering the biggest jump in the unemployment rate since the Great Depression. While the employment situation has improved markedly since then, participation in the labor market remains surprisingly slow. Economists have identified a number of possible reasons, including disruptive school closures, which have relegated many former workers to unpaid childcare duties; a growing segment of the country’s aging population is opting for early retirement; higher personal savings rates, which gave workers more flexibility in their job searches; and lower levels of immigration.
With so many potential workers shelved, companies have raised wages – which is good news for job seekers, but adds to the cost pressures companies face on top of bottlenecks of the supply chain.
“We believe that in general, inflation should come down but should remain elevated relative to pre-pandemic trends,” Mahajan said. “We are starting to see early signals that supply chain disruptions may start to ease. Where we are still waiting for improvements is the labor shortage.
Gillum said, “It’s going to be difficult to engineer a soft landing,” but he also said clear communication from Fed officials could help soothe nervous Wall Street. “Rate hikes by themselves do not mean that stock markets will sell off. It just means we are in the middle of the cycle,” he said. “That doesn’t mean the economy is on the brink of recession.”