The Fed’s first meeting of the year will take place this week, with the industry eager to see what Chairman Jerome Powell has to say about the December 2021 inflation hikes and the first rate hikes in March announced at previous meetings.
François Rimeu, Senior Strategist La Française AM
The Federal Open Market Committee (FOMC) is likely to use its January meeting this week to set the stage for a rate hike in March and to begin formulating a plan for balance sheet reduction. Please find below what we expect: The Federal Reserve System (FED) to confirm a rate hike in March following the publication of very robust data on employment and prices.
As uncertainty remains very high, especially on the inflation front, we expect the FED to remain data dependant regarding the pace of rate hikes in 2022.
The FED to confirm the tapering pace ($30bn per month), with quantitative easing ending in March. We do not think the FED will end purchases abruptly at this meeting.
We also expect the FED to give more information regarding the balance sheet runoff, without committing to a specific timeline (nor to a specific amount) to avoid any panic reaction on financial markets. The formal announcement could come during the summer, after the first two rate hikes (March and June).
We do not expect the FED to indicate being open to the possibility of a 50bps hike in March.
Given recent comments from FOMC members supporting the current hawkish bias of the FED (and thus market pricing), we do not expect a significant hawkish surprise at this meeting.
In conclusion, the statement is unlikely to differ considerably from the December statement. Consensus seems to be leaning towards a hawkish tilt, with financials markets already short on US treasuries (short end of the curve). We expect a modest steepening of the US curve.
Paolo Zanghieri, Senior Economist Generali Investments
At the January meeting, the Fed will confirm its hawkish pivot. It is likely to become more explicit about the pace of interest rates, while the disclosure of the details for the balance sheet will have to wait for Spring. Since the December meeting the economy has continued to improve but inflation has proved more stubborn and widespread than anticipated.
Moreover, earlier this month, in his confirmation speech Chair Powell explicit said that persistently high inflation may stand in the way of attaining full employment. This echoes warnings by several FOMC members, hinting that more than the three hikes pencilled for 2022 in the December meeting may be required. Markets are currently prices slightly more than four rate rises this years. Without a rapid fall of inflation in spring, a combination of four rate hikes and the beginning of quantitative tightening (i.e. the reduction od the bond holdings) will be needed. Accordingly, we expect Powell to strongly suggest that the first rate hike will already occur in March.
Only very bad readings of the January labour market report and/or a surprisingly fast and sizeable tightening in financial conditions over the coming week would push the Fed to delay the first rate increase. There has been speculation about a bolder action on rates, i.e. a 50 bps increase, aimed at showing a strong determination to fight inflation. We deem is highly unlikely, as raising rates at the predictable pace of 25 bps allows the Fed the flexibility it needs given the uncertain economic outlook. Moreover, a sharp policy rate increase may lead to an unwelcome tightening in financial conditions.
There may be more information about how and how fast the Fed will shrink its balance sheet, but not a full disclosure. In December Powell stated that quantitative tightening will start earlier and will be faster than in the last episode; afterwards several FOMC members have reiterated this, without providing much additional information on what “earlier and faster” means. Next Wednesday, Powell may start discussing the possible scenarios in order to start steering expectations. Yet many question will likely remain unanswered, such as the limits to the amount of bonds not reinvested, the possibility of selling asset on top of not reinvesting maturing bonds and how the composition of Fed’s balance sheet will change during the process. We expect quantitative tightening to begin in Q3, after two rate hikes, and therefore the May meeting will be a suitable moment for the Fed to spell out the details.
Franck Dixmier, Global CIO Fixed Income at AllianzGI
In the last six months, the US Federal Reserve (Fed) has made a major change in strategy: inflation, which it had struggled to characterise for much of 2021, has become its main concern. That shift is well illustrated by the December Monetary Committee Minutes. These have indeed revealed a more hawkish Fed than expected, particularly on employment, of which it notes the “very tight” market.
They also signaled a willingness to hike rates sooner and faster than initially expected. Some Federal Open Market Committee (FOMC) members even suggested starting to shrink the Fed’s balance sheet. Since then, the publication of inflation at 7% year-on-year in December can only reinforce the need for a less accommodative monetary policy.
It remains to be seen whether this shift is really sincere, as the dichotomy between the power of the speech and the current inaction is strong. In fact, beyond the rhetoric, it is difficult to detect the slightest sense of urgency to implement a tightening of financial conditions. Admittedly, the Fed has begun its tapering, but it continues to buy assets in the market, even though there is no economic argument for doing so. And why wait until March to raise rates? The constraint of waiting for the end of tapering, scheduled for March, to raise rates was set by the Fed itself….
The Fed appears to us to be losing its bearings. The evolution of inflation continues to be difficult to characterise. Despite the arguments in favour of a decline in inflation in the second half of the year, the persistence of the health crisis, and the zero-Covid strategy of certain countries, in particular China, could cause further disruption of production chains, maintaining upward pressure on prices. Moreover, the Fed is caught between strong political pressure to raise rates to counter inflation and its hesitation to tighten financial conditions in the context of a slowdown in the American economy in 2022. In fact, after a significant catch-up in 2021, demand for goods is expected to slow as real wages are now negative, and public demand will benefit from less fiscal support. Finally, if the arguments for raising rates are met, the level of increase is less obvious to determine for a Fed fearing a monetary policy error.
We, therefore, expect a firm speech on the tightening of its monetary policy to counter inflationary threats, but no concrete announcement apart from the confirmation of a first rate hike in March. The Fed’s objective at the FOMC meeting should be to buy time, and therefore visibility for its economic forecasts to regain credibility.
This meeting should have no impact on the markets. In recent months, they have revised their expectations upwards, with five rate hikes planned for 2022, which has already led to a correction across the entire curve.
Erick Muller, Director, Product and Investment Strategy, Muzinich & Co
The US Federal Reserve (Fed) will meet on Wednesday 26th January against a backdrop of volatile markets. US equities are down 10% year to date, and this is the first test for the Fed: how to stick with a fast rate hiking narrative in a falling equity market?
Since the December meeting, the Fed’s pivot on inflation expectations has been clearly stated in many Fed member speeches. Inflation is high and, while its expected to decline in the next few quarters, the speed and magnitude of the decline may not meet initial expectations.
In addition, US employment numbers have been strong, and it is highly probable the Fed will declare that both inflation and employment conditions will be met sooner than initially expected. As a matter of fact, the unemployment rate has fallen close to estimated full employment levels very quickly, and wages are rising fast, while hours worked are also at elevated levels.
We believe markets will expect to get a way of measuring the urgency of the potential monetary adjustment as well as a sense of its speed from Wednesday’s communication, because the December dot plot is obsolete. The Fed is expected to announce changes in three tools:
Our expectation is that the asset purchase programme will be stopped in mid-February. Recent declarations from Fed officials have suggested that three to four hikes may be delivered this year and it is important to end the tapering relatively soon, should the Fed want to start raising rates in March. However, an immediate stop would be a signal that the calendar of the rate lift-off was accelerating and therefore may increase the market correction.
The market has already priced four hikes of 25 basis points (bps) each for March, June, September and December 2022, a far steeper curve than last December’s pricing. The question is whether the Fed will want to see an even steeper forward curve on the front end as soon as this meeting. We do not think so, especially in an unstable equity market. This is especially since the Fed may want to communicate on the runoff of the balance sheet and prepare the markets as early as this Wednesday. It could take the form of a formal announcement that the staff have been asked to come up with a plan to be discussed in the next couple of Fed meetings. This would make the July meeting a real candidate for the beginning of the balance sheet runoff and would reinforce the case for a start of policy rates hike in March.
So far in 2022, the yield move has been in real yields as market-priced inflation expectations have been declining to the lows of a three-month range. In our view, real yields should continue to move up in 2022, although this is no linear trend, and we may see a pause yield rises momentarily.
What is as stake with this week’s Fed meeting is the ability to stabilise inflation expectations which requires an ongoing “hawkish” narrative. On the other hand, the tightening of financial conditions through a sharp decline in market valuations, even before the start of a policy rate adjustment, would be a complication and not a solution to the Fed’s objective. Part of the solution to this delicate equation lies in corporate earnings projections and the equity market reaction. It is possible the Fed will want to wait for the fourth-quarter earnings season to end first and see what the markets can take further.
James McCann, Deputy Chief Economist, abrdn
The Fed continuesto receive nasty surprises on the inflation front as it battles a perfect storm of rising energy prices, rampant inflation in durable goods and surging rents. It will still expect some of these pressures, particularly around energy prices and goods, to moderate as we move through 2022, but Omicron could disrupt this progress.
And accelerating wage growth increases the risk that we see more persistent inflation across domestic services, if firms try and protect margins in the face of continued increase in input costs.
Against this backdrop, this meeting is likely to bring a few surprises in terms of direct policy moves, but will confirm the Fed’s recent hawkish pivot and heavily signal the start of rate hikes in March. We think the risk of a short term hawkish surprise – such as ending QE earlier than March – is relatively low, but further out the forecast horizon the risks are skewed towards the Fed delivering more than the 100bps in rate hikes we expect this year. A faster withdrawal of monetary policy support will coincide with a more abrupt tightening in fiscal policy as pandemic support measures fully roll off and our expectations for Build Back Better legislation shrink. Both of these point to weaker growth ahead.
Mark Nash, Head of Fixed Income Alternatives at Jupiter Asset Management
The Federal Reserve’s January meeting is finally upon us after a hectic start to the year for risk markets. With no projections due at these meetings, all ears will be on the rate signal for the March meeting and the outlook for quantitative tightening (QT) to begin in 2022. A signal for a 25bps hike in March is looking likely, backed by talks of ‘maximum employment’ and ongoing inflation pressures.
Plans for QT are also set to be discussed. This would likely begin mid-year, but won’t be finalised yet as bond buying continues into March.
Financial conditions have finally tightened in the US with the decline in stocks, widening of credit spreads and rising real interest rates. The Fed, after their aggressive four-month hawkish shift, will welcome this development and therefore be more comfortable following the market’s lead and not wanting to surprise on the upside or downside. Tentative signs of easing bottleneck pressure will also be welcomed by the Chairman. but his hawkish message on inflation, which has been heavily priced into markets, will remain steadfast.
We believe the QT message is key, as in this tightening cycle the runoff of the Fed’s balance sheet is likely to be faster, meaning the Fed funds rate won’t have to do all the work as it has in previous cycles. This should ease upward pressure on the dollar and steepen the curve, demonstrating that unconventional policy can work both ways.
Lastly, as growth stocks and speculative assets underperform and policy supports a weaker dollar bias than in the past, this would be more in line with the US Administration’s onshoring and equality agenda and prove more politically acceptable.