Fed Takes Foot Off Gas: Braces to Hit Brakes

The Federal Open Market Committee (FOMC) - the policy setting arm of the Federal Reserve - unanimously voted to end the asset purchase program by March instead of June of 2022. The decision by the FOMC to end its asset purchase program sooner effectively lifts a foot from the accelerator of an economy that is booming. One could argue that the Fed should have ended asset purchases even sooner, but we are within a six-month window on when it could have done that, which is pretty rapid.

The Fed retired the word “transitory” with regard to its discussion on inflation in its statement on policy. The current inflation is global in scope and being exacerbated by strong demand emanating from the U.S. The Fed is keenly aware that it is the central bank to the world. It would like to keep rate hikes and policy shifts measured to temper inflation without flattening the recovery entirely. That is easier said than done.

The next major decisions will be when to start raising short-term interest rates and when to begin the process of allowing the balance sheet to shrink. The FOMC allowed the balance sheet to shrink at the same time it was raising rates in 2018. Committee members did not worry about shrinking the size of the balance sheet when they first raised rates in December of 2015. It is unclear how rapidly the Fed will allow its balance sheet to shrink, but it should happen much quicker this time around.

Chairman Jay Powell was asked about when the balance sheet would be reduced. He was not ready to commit to a timeline but I would expect that initial discussion on shrinking the balance sheet will show up in the minutes from this meeting, which will be released in three weeks. Powell did admit that financial conditions could change much more rapidly than they did in the past. Any reduction in the balance sheet could amplify the tightening effects of rate hikes. He is walking a tightrope here, wanting to dampen inflation but not derail the recovery.

Forecasts by participants submitted (before the FOMC met) revealed more concerns about a lingering inflation and a more rapid return to full employment than we have seen previously. The dot plot, which tracks participants' expectations for rate hikes, shows that all participants now expect at least one rate hike next year. Most expect three rate hikes in 2022; two expect four rate hikes next year. Fed participants also envision rate hikes happening more rapidly, through 2024, than in the past. We are forecasting three rate hikes in 2022, starting in June, and four rate hikes in 2023.

The Federal Reserve has not been terribly accurate with rate hikes in the past. This marks the first time that the Fed has openly chased instead of preempted inflation since the 1980s. Some former Fed officials think the Fed will have to move even faster and go higher on rates than those currently in the Fed system. Former New York Fed President Bill Dudley has argued that the Fed funds rate could be hiked to 3% or 4% to rein in inflation.

The risk is the Fed could move from patience to panic. Rate hikes in 2022 and 2023 could easily be more rapid than the Fed has forecast. Powell admitted that 1) the improvement in employment has been substantial, which is much more bullish than in the past, and 2) if need be, the Fed can prioritize inflation over employment, given the damage inflation could cause the economy if left unchecked.

Bottom Line
The Fed has made a full pivot from viewing inflation as transitory to more persistent and problematic. The Fed is clearly worried about inflation becoming more entrenched, even as it starts to retreat in 2022. A more persistent inflation could justify even more rate hikes than the Fed has penciled in for the year. Powell would clearly like to take things a bit more slowly than some of his colleagues. He believes that the lags implicit in rate hikes are much shorter than they once were, given the global nature of financial markets today.

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