(Reuters) – With the Federal Reserve almost certain to hike interest rates this week for the first time in more than three years, investors will be focused on how it plans to curb a surge in inflation inflamed by the Ukraine crisis without triggering a recession.
The U.S. central bank is expected at the very least to raise borrowing costs at each of its next three policy meetings as it scrambles to address the fastest inflation in 40 years. Consumer prices rose 7.9% in February on an annual basis.
But having waited until it was sure the economy and labor market had recovered from the COVID-19 pandemic, the Fed also risks tightening monetary policy just as growth is slowing. Western sanctions to punish Russia for its invasion of Ukraine have sent the prices of oil and other commodities soaring, adding to uncertainty over the trajectory of the global economy.
“The policy path set forward is going to be one for further increases,” said Kim Rupert, managing director of global fixed income analysis at Action Economics, who added that Fed Chair Jerome Powell and his fellow policymakers would likely take a cautious data-dependent approach. “They really can’t do anything else given the uncertainties from the war.”
Powell’s news conference after the end of the two-day policy meeting on Wednesday will be closely watched for possible clues as to how aggressive the Fed may be in fighting inflation and whether it will risk a recession to dampen price pressures.
Bond markets are already betting on a possible economic contraction down the road, with the two-year, 10-year U.S. Treasury yield curve flattening to only 25 basis points, a much smaller gap than at the beginning of previous Fed tightening cycles. An inversion in this part of the yield curve is seen as a reliable indicator of a recession in one to two years.
The Fed’s benchmark overnight interest rate ahead of this week’s policy meeting was 0.08%. Fed fund futures traders are pricing in a policy rate of 1.75% by the end of this year. [FEDWATCH]
The Fed will also on Wednesday release updated quarterly economic projections and a “dot plot” showing policymakers’ interest rate projections. Markets expect the Fed to indicate more rate hikes this year and possibly a higher terminal rate, the neutral interest rate seen as consistent with full employment and stable prices.
“Our sense is that they are going to want to front-load the policy tightening and probably go at a slower pace in 2023,” said Zachary Griffiths, a macro strategist at Wells Fargo (NYSE:WFC). “It will be interesting to see if any policymakers are starting to revise up their expectations for the terminal rate in response to expectations that inflation will be a fair bit higher perhaps throughout this cycle than what we saw throughout the last economic expansion.”
The new economic projections will show if officials see a near-term easing of price pressures and to what extent GDP growth expectations have been lowered.
BALANCE SHEET REDUCTION
The Fed also may indicate how fast and large the cuts to its $8.9 trillion balance sheet will be when the bonds it holds start rolling off the books, which many analysts expect to happen in May or June.
The central bank also is widely expected to announce that it has ended the massive bond-buying program initiated in early 2020 to blunt the damage of the pandemic. The asset purchases had dwindled since November 2021.
In January, the Fed said it did not anticipate it would sell its holdings of Treasuries, but instead would allow them to mature without being replaced. It may, however, sell its mortgage-backed securities, which could relieve some of the pressure in hot housing markets.
Meanwhile, money markets will key in on whether the Fed raises the rate it pays investors to borrow Treasuries overnight in its repurchase agreement facility by 25 basis points, or only 20 basis points, following a five-basis point increase last June that was meant to stop short-term interest rates from falling too low.
That could impact demand for the Fed’s reverse repo facility, in which investors borrow Treasuries overnight, and which continues to see near-record daily volumes of around $1.5 trillion, said Padhraic Garvey, regional head of research for the Americas at ING.
A smaller rate hike for this facility could “unwind some of this excess cash that goes back into that window on a daily basis,” he said. That said, given it’s the first rate hike, the Fed may want to simplify the messaging by keeping the 25-basis-point hikes consistent across rates and highlight that there are more to come, he noted.
The central bank raised counterparty limits in the reverse repo facility twice last year to address excess liquidity amid a dearth of safe, short-term investments.
Source: Economy - investing.com
