Federal Reserve set to take big step towards first rate hike

Federal Reserve Chairman Jerome Powell attends the House Financial Services Committee hearing on Capitol Hill in Washington on September 30, 2021.

Al Drago | Reuters

The Federal Reserve is expected to announce a radical policy change on Wednesday that will pave the way for a first interest rate hike next year.

Markets expect the Fed to speed up the end of its bond buying program, changing the end date from June to March.

This would allow the central bank to start raising interest rates from zero, and Fed officials are expected to release a new forecast showing two to three interest rate hikes in 2022 and three to four more in 2023. Previously, there had been no consensus for a rate hike in 2022, although half of Fed officials expected at least one.

After its two-day meeting on Wednesday afternoon, the central bank is also expected to recognize that inflation is no longer the “transitional” or temporary problem that officials thought it was, and that rising prices price could be a bigger threat to the economy. The consumer price index rose 6.8% in November, and it could be still warm in December.

“I think it’s high time to get out of the easing activity,” said Rick Rieder, director of global fixed income investments at BlackRock.

The Fed implemented its quantitative easing program to combat the effects of the pandemic in early 2020, and it also reduced its target federal funds rate to zero.

Market preparation

Fed officials in mid-November began discussing the idea of ​​a faster cut, and they were successful in shifting market expectations to seek an earlier end to the $ 120 billion a month d ‘bond purchases. Market expectations have also shifted regarding the timing of interest rate hikes from late next year to early June.

Rieder said that by ending bond purchases earlier, the Fed is giving itself the opportunity to raise interest rates. “I think they can raise rates in 2022. I don’t think there is any rush,” Rieder said.

He said the Fed could increase twice in 2022 and three to four times in 2023.

“I think the data will determine when they’re going to start. I don’t think the Fed has any clue that they have to start in any given quarter,” he said. Rieder said the Fed would then be able to better understand how far inflation persists and whether the virus continues to pose a risk to the global economy into the new year.

While the Fed should appear hawkish or in tightening mode, Fed Chairman Jerome Powell could be much less hawkish when he addresses the press at 2:30 p.m. ET on Wednesday, 30 minutes after the release of the press release. and forecasts by the central bank. .

“For them to justify accelerating the reduction, the FOMC’s statement must be pretty blunt,” said Vince Reinhart, chief economist at Dreyfus & Mellon. Powell will likely discuss both rising inflation, but also why the Fed might remain somewhat cautious.

“We have taken our ‘transitional’ retirement, but the transition seems to be important because it has made a rapid transition,” said Reinhart. “He could spend time talking about the mutations in the virus and the risks to the outlook and things that could go wrong.”

joker balance sheet

The big wild card for the markets is what the Fed says about its balance sheet, which was $ 4.1 trillion in January 2020 before the pandemic but has swelled to $ 8.7 trillion. As balance sheet securities mature, the Fed replaces them, separately buying billions more in treasury bills each month.

“It would be very surprising for the market if they said that we don’t need to keep the size at these levels,” Rieder said. The Fed is more likely to reduce its balance sheet after raising interest rates, he said.

But the Fed’s final balance sheet reduction could sometimes have an even bigger impact on the market than a hike in interest rates, he said.

Economists at Goldman Sachs have presented a scenario for the runoff, which they believe may be less conservative than it was in the last cycle following the financial crisis. The trickle-down would start if the Fed let the securities simply mature, and by not replacing them, the balance sheet would start to shrink.

“We expect the fourth rate hike to come in the first half of 2023, so our best guess so far is that the runoff will start around that time. Research on balance sheet policy implies that the impact of the runoff on rates interest rate, broader financial conditions, growth, and inflation are expected to be modest, well below that of the rate hikes we expect, ”they wrote in a note. “However, markets have at times reacted strongly to reductions in balance sheet accommodation in the past.”

Diane Swonk, chief economist at Grant Thornton, expects the Fed to discuss the balance sheet at this meeting but take no action.

“I think he will be asked about the track record,” Swonk said. “They tried to let their balance sheet drain before. It’s something we should expect to happen also faster this time around. I don’t think they’ve made that decision yet… I don’t. wouldn’t be surprised to see it in the [meeting] minutes.”

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