This past Tuesday and Wednesday took place the first Fed meeting of the year, mainly focused on inflation. The Fed did not specify a date for rising the interest rates, but everything points to March. “With inflation well above 2% and the labour market strong, the Committee expects that it will soon be appropriate to raise the target range for the federal funds rate,” the Federal Reserve said. So, for the time being, rates remain unchanged -in the 0% range-.
The US central bank seeks to contain inflation, which last December reached 7%, the highest rate in the US since 1982. Here are the first reactions from international fund managers.
Anna Stupnytska, Global Marco Economist at Fidelity International
What happened? At the January meeting, the Fed took no policy action, in line with expectations. The Fed’s main objective this month was to communicate its next steps for the tightening cycle that is being kicked off this year. The statement provided new guidance on the lift-off which “will soon be appropriate” and on the balance sheet, with asset purchases now expected to end “in early March”.
Notably, the statement also included new references to inflation “well above 2 percent” and a “strong labour market”. Clearly, inflation is the Fed’s prime concern right now, suggesting the bar for changing the hawkish narrative in the near term is exceptionally high. This is also helped by overall financial conditions which, despite the recent sell-off in equity and bond markets, remain extremely easy. This should allow the Fed to hike at 25bp increments 3-4 times this year.
We also expect the balance sheet runoff to start earlier than in the previous episode – after one or two hikes – and to be steeper, at least initially. Assuming the ratio of QE to QT pace is held the same as before, the max runoff cap is likely to be about USD90-100bn per month for both Treasuries and mortgage-based securities, which is double the max cap seen in the last cycle. If started in the second half of this year, QT at this pace could last until 2025 if the Fed is to take the balance sheet to its pre-pandemic size of 20% of GDP. Risks are skewed towards a faster runoff if upside inflation surprises continue and financial conditions remain easy despite rate hikes – in that case, the Fed might need to be more decisive to protect its credibility.
Our interpretation
Having underestimated the breadth and persistency of inflationary pressures and having fallen significantly behind the curve as a result, it is now time for the Fed to protect its credibility as an inflation targeter. But how fast and how far this tightening cycle can go depends on a number of factors along the way, not least on the inflation dynamics and the terminal level of real rates the economy and markets can digest. While we believe 3-4 rate hikes and some balance sheet runoff is achievable in 2022 (though of course the balance sheet devil is in the detail), we are more sceptical on the tightening pace in 2023-24 that is currently priced in by the markets. With the debt burden so much higher after the pandemic, real rates have to remain in the negative territory for a long period of time, for the debt trajectory to stabilise at sustainable levels. Indeed, we believe maintaining negative real rates is currently the implicit policy objective of all major central banks. In this respect, the Fed’s policy action over the next few months is likely to be guided by real rates – a major shock resulting in positive real rates would likely lead to a more dovish stance. Ultimately, this tightening cycle is unlikely to be much steeper or longer-lasting than the last.
James McCann, Deputy Chief Economist, abrdn
A bumpy week in markets has done little to push the Fed off its accelerated tightening schedule, with today’s meeting setting the stage for an interest rate hike in March. While the central bank has been sensitive to market stress in the past, it is harder to change course with inflation at 7%, the unemployment rate below 4%, wage growth accelerating and real interest rates deeply negative.
Looking forward, inflation remains the big risk for markets. If the Fed is wrong that this will start to moderate in 2022, it will be forced to go faster on policy tightening, even if this proves disruptive for asset prices, and consequently investors.
Sandrine Perret, Senior Economist, Vontobel
FOMC update – sticking to hawkish plans: liftoff in March, quantitative tightening to follow
Summary: Anyone who was expecting a turnaround in the Fed’s policy stance today will be disappointed. The Fed is sticking to its course, with another hawkish press conference by Chair Powell today. He was very clear that “it is their job to bring inflation down” and Powell appeared very serious on the issue. The FOMC continues with its plan of tightening this year and is also indicating intentions to move much faster than during the previous cycle (2015). The Fed will remain attentive to risks and the pandemic impact on activity which is expected to dissipate again after Q1.
We think 4 hikes starting in March and a balance sheet reduction starting mid-year (probably June) is a now the minimum that the Fed will deliver. After Powell’s Q&A, we cannot rule out the Fed to hike rates more aggressively at every single meeting this year. The negative market reaction post-FOMC and a large increase in 2y yields and rates forwards suggest the same reading of Powell’s message.
Details: Overall, there was no turnaround in the FOMC in January from what we learn in recent speeches since the last policy meeting in December. With no Summary of Economic Projections published this month, the entire focus was on the introductory statement and Powell’s Q&A regarding the Fed tightening plans.
The statement was little changed, with the labor market now seen as “strong” and inflation “well above 2%”. Hence policy liftoff will be coming “soon” – which the Fed’s way to announce a rate hike at the next meeting on March 16th (see full 2022 calendar below). The voting was unanimous despite the rotation in Fed’s voters with the new year. The Fed decided to stick to the tapering plan and will conclude purchases in early March, as expected.
Chair Powell was however very hawkish during the press conference. In his view, the economy is at a much better place than it was in 2015 when the Fed started the last hiking cycle. Powell repeated this many times during the press conference, with growth above potential, inflation above target and a “very very” tight labor market. So with the economy strong, the Fed is sticking to its tightening plans and the aim to move “steadily” away from the large accommodation provided during the pandemic.
On rate hikes, the FOMC broad consensus is still for a March hike, as was depicted in the FOMC statement. Powell refrained from answering a question on the pace, saying there is no pre-set plan for Fed’s coming hikes. But the comparison to the last hiking cycle left no double that the Fed could move to hikes at every meeting from here should conditions permit to do so. A 50bps hike in March is also on the table.
Regarding the balance sheet runoff, the Fed released some “principles” for the balance sheet reduction. Fed officials expect the central bank’s balance sheet reduction to begin after they start raising rates. But they have not made decision on time, the pace and other details regarding the runoff. The Fed will discuss it at upcoming meetings and want to balance sheet reduction to be orderly and predictable. Powell stated that they will need at least one meeting after hiking rates (in March) for the discussion. Over the longer run, the Fed intends to primarily hold Treasuries.
Regarding economic activity, Powell anticipates that Omicron will weight on growth in Q1 (we also do), given the size of the current wave and health-related containment measures. Uncertainty regarding the impact of the pandemic also remains. That said, labor market demand remains historically strong and improvement is widespread across jobs categories and wages seeing upward pressure. And Powell was of the view that the US post-Covid recovery is the strongest of any country so far.
Inflation remains very high and supply-chain problems are larger and longer lasting than thought, and could persist until well into H2. Risks regarding inflation are still to the upside in Powell’s mind – with the current situation worse than at the December meeting – and that is a direct risk per-se to the economic expansion the Fed is aiming at.
Finally, on markets and financial conditions, Powell said that the Fed looks at a broad range of financial conditions indicators, and also at sudden changes in financial conditions that would be inconsistent with their dual goal. So far, he said that the communication that they have been giving is reflected and anticipated by the market (with hikes now priced-in) and the current market understanding for their policy stance is also appropriate in his view. So the recent market turbulences does not seem to be pushing the Fed off course just yet.
David Roberts, head of the Liontrust Global Fixed Income Team
The Federal Reserve refrained from raising rates. However, they signalled both an end to asset purchases and a rate increase for March. No news there.
Importantly, Fed Chair Powell did not deny the possibility of changes to Fed Funds at each FOMC meeting this year. If it happens, that would be roughly double what the market was expecting.
Needless to say, the impact so far has been to further weaken risk assets and continue the growth-to-value rotation. There are also increasing signs the general market is worried about the possible extent of action, with major equity indices moving into negative territory year-to-date.
Bonds, especially US ones, have fallen. Short dated yields are back around 18 month highs. Having been bearish for most of that period, we are starting to believe we will see positive returns from the short end of the market over the coming year and will shift our portfolios more into this part of the market. Prior, we have been under-invested.
Our one concern is that the market has not woken up to the possibility of a 50 basis point hike in March. That isn’t our central case but it certainty could happen. If so, we are in for a lot more volatility in the months ahead.
