The Federal Reserve Board building is pictured in Washington, USA on March 19, 2019.
Leah Millis | Reuters
While the Federal Reserve managed to sort out its short-term plans this week, long-term issues remain more than enough to scare investors.
Markets initially reacted positively to the Fed’s statement after Wednesday’s meeting in which it said it would strike back against booming inflation by accelerating the reduction in its monthly bond purchases and likely hike rates three times in 2022.
Thursday’s market action was less convincing, however, as rate-sensitive stocks fell sharply and yields on government bonds, which could have risen amid the Fed’s tightened monetary policy, instead fell.
One reason for the move, especially in bonds, is that the market may not be entirely convinced that the Fed can do what it outlined in its forward-looking forecasts.
“The bigger challenge for the Fed and the markets is that they may not have the headroom to hike rates as much as they want without reversing the yield curve and slowing the economy more than they want,” said Kathy Jones, Head of Fixed Income Strategist at Charles Schwab. “What the market is telling you is that the Fed doesn’t have much leeway to go beyond two or three hikes.”
On the way to hiking
What the “dot plot” of the projections of the 18 members of the Federal Reserve Open Market Committee said was that the Fed is ready to go beyond just a few increases.
Each member has announced at least one rate hike in 2022, two even up to four hikes. The majority of members saw the Fed approve three-quarter percentage point hikes next year, followed by three more in 2023 and two in 2024.
However, Jones believes the outlook may be too aggressive given the challenges the economy is facing, from the ongoing pandemic to demographic and staffing constraints that have kept inflation and interest rates in check for more than a decade .
“Raising rates this significantly could be quite difficult without tightening financial conditions much more than you are likely to want to see,” she said.
Limits on rate hikes could jeopardize the Fed’s credibility as an inflation fighter and fuel fears of asset bubbles. Markets reacted very positively to the statement on Wednesday, which reflected both relief that the FOMC’s statement was not overly restrictive on monetary policy while the scope for tightening financial conditions was limited.
With inflation at a 39-year high, it becomes difficult to strike the right balance between stabilizing prices and propping up the economy.
“We believe the Fed has fallen behind the curve since the beginning of this year and remains well behind the curve today,” said Mark Cabana, head of US interest rate strategy at Bank of America, in a statement.
“The Fed’s new policy is highly non-linear and creates a dangerous endgame,” added Cabana. “Once the Fed has achieved its goals, it should adopt a neutral monetary policy stance, no super-stimulating zero interest rate and a massive balance sheet. In our view, the Fed has essentially achieved its goals already.”
The tightening road ahead of us
The balance sheet cut is a completely different topic that the Fed will have to grapple with in the longer term.
Chairman Jerome Powell said at his news conference after the meeting that policymakers have just started discussions about a final stock cut. This process would begin after the expansion of bond purchases is complete, and probably not last, until the Fed has some rate hikes under its belt.
It is a difficult balance to bring about a soft landing in monetary policy that has been accommodating at unprecedented levels. The last time, in 2017-2019, the “quantitative tightening”, or QT as it came to be known, didn’t end well as markets revolted after Powell said the process was on “autopilot” at a time when the market revolted US economy weakened.
All of this is part of what Krishna Guha, head of global policy and central bank strategy at Evercore ISI, calls the “Powell Conundrum” of curbing inflation while helping the economy through a troubled time.
“A relatively aggressive QT may be necessary if, over time, the Fed fails to gain traction at the longer end of the yield curve and broader financial conditions,” Guha said in a press release. “This is the most obvious way in which the ‘Powell conundrum’ needs to be carefully examined by investors and could contain the seeds of its own destruction, although this is more relevant on a timeline through 2022 and beyond, not the next few weeks or even Months. “
In the meantime, the ride for the markets could be an upset stomach, especially after Fed officials return to the public stage and make political speeches again. New York Fed President John Williams will be at CNBC’s Squawk Box at 8:30 am ET on Friday.
“The anti-inflation measures we are talking about could cause quite a bit of volatility in the short term,” said Christopher Whalen, chairman of Whalen Global Advisors.
However, Whalen believes that the Fed would give way to the markets if policies became restrictive.
“America’s unspoken truth is that we need inflation in this society to keep political peace,” he said. “I’m not looking for a big anti-inflation hit like this [Powell]because if the market faints, it will fold very quickly. “