- The Federal Reserve is expected to announce a more rapid transition away from its easy policies after its meeting Wednesday, as it sets the stage for the first interest rate hike next year.
- The Fed is also likely to provide a new description of how it views inflation, and acknowledge that it no longer views it as transitory.
- One wild card that market pros are watching closely is what the Fed says about its $8.7 trillion balance sheet and whether it tips when it might start to shrink it.
The Federal Reserve is expected to announce a dramatic policy shift Wednesday that will clear the way for a first interest rate hike next year.
Markets are anticipating the Fed will speed up the wind-down of its bond buying program, changing the end date to March from June.
That would free 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 another three to four in 2023. Previously, there had been no consensus for a rate hike in 2022, though half of the Fed officials expected at least one.
At the end of its two-day meeting Wednesday afternoon, the central bank should also acknowledge that inflation is no longer the “transitory” or temporary problem officials had thought it was, and that rising prices could be a bigger threat to the economy. The consumer price index rose 6.8% in November, and it could be hot again in December.
“I think getting out of the easing business is very much overdue,” said Rick Rieder, chief investment officer of global fixed income at BlackRock.
The Fed put its quantitative easing program in place to combat the effects of the pandemic in early 2020, and it also slashed its fed funds target rate back to zero.
Preparing the markets
Fed officials in mid-November began discussing the idea of a more rapid taper, and they have successfully swung market expectations to look for a faster end to the one-time $120 billion a month in bond purchases. Market expectations have also moved forward on the timing of interest rate increases from starting late next year to beginning in June.
Rieder said by ending the bond purchases sooner, the Fed is giving itself the option to raise interest rates. “I think they can hike rates in 2022. I don’t think there’s a rush,” Rieder said.
He said the Fed could hike twice in 2022, and three to four times in 2023.
“I think the data will determine when they are going to start. I don’t think the Fed has any notion that they have to start at any given quarter,” he said. Rieder said the Fed will then be able to get a better handle on how persistent inflation is and whether the virus continues to be a risk for the global economy in the new year.
While the Fed is expected to sound hawkish, or in tightening mode, Fed Chairman Jerome Powell could sound much less so when he speaks to the press at 2:30 p.m. ET Wednesday, 30 minutes after the statement and forecasts are released by the central bank.
“For them to justify speeding up the taper, the FOMC statement has to be pretty abrupt,” said Vince Reinhart, chief economist at Dreyfus & Mellon. Powell will likely discuss both hotter inflation, but also why the Fed could remain somewhat cautious.
“We retired ‘transitory,’ but transition seems to be a big one because he made a fast transition,” said Reinhart. “He could spend some time talking about the virus mutations and the risks to the outlook and the things that could go wrong.”
Balance sheet wild card
The big wild card for markets is what the Fed says about its balance sheet, which was $4.1 trillion in January, 2020 before the pandemic but has swollen to $8.7 trillion. As securities on the balance sheet mature, the Fed replaces them, thereby separately buying billions more in Treasurys each month.
“That would be very surprising to the market if he came out and said we don’t need to keep the size at these levels,” said Rieder. The Fed is more likely to reduce the balance sheet after it raises interest rates, he said.
But the Fed’s ultimate reduction of the balance sheet could sometimes have an even bigger impact on the market than an interest rate hike, he said.
Goldman Sachs economists laid out a scenario for the runoff, which they said could be less conservative than it was in the last cycle following the financial crisis. Runoff would begin if the Fed allowed securities to simply mature, and by not replacing them, the balance sheet would begin to shrink.
“We forecast that the fourth rate hike will come in 2023H1, and our best guess for now is therefore that runoff will begin around that time. Research on balance sheet policy implies that the impact of runoff on interest rates, broader financial conditions, growth, and inflation should be modest, much less than that of the rate hikes we expect,” they wrote in a note. “However, markets have sometimes 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 not take action.
“I think he will be questioned about the balance sheet,” said Swonk. “They did try to let their balance sheet drain previously. That is something we should expect to happen as well more rapidly this time. I don’t think they made that decision yet…I wouldn’t be surprised to see it in the [meeting] minutes.”
Source: Economy - cnbc.com
