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Fed Paves the Way for Rate Hikes

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The Federal Open Market Committee (FOMC) - the policy setting arm of the Federal Reserve - is scheduled to meet January 25-26. Everyone who participates in the meeting expects at least one rate hike in 2022; most expect several.

The Powell Fed has concluded that COVID variants are more inflationary than disinflationary, due to the impact they have on supply chains and the supply of labor. The statement following the meeting will acknowledge the disruption to economic activity triggered by Omicron, while still signaling a liftoff in rates to begin in March.

One of the most hawkish members of the Federal Reserve, President Jim Bullard of the St. Louis Fed is rotating into a voting position on the FOMC. Dissents pushing the Fed to act more aggressively on rate hikes cannot be ruled out, even as the Fed begins the process of raising rates. Bullard will be pushing to taper asset purchases even sooner than the Fed decided and could dissent as soon as his first meeting, arguing that the Fed should end asset purchases in February instead of March.

Fed Chairman Jay Powell will drill home the point that the Fed is firmly focused on containing inflation while still allowing the labor market to heal. That is easier said than done. We could easily lose ground on employment to Omicron in January even as the Fed prepares rate hikes in March.

Powell is expected to prime the pump for a reduction in the Fed’s massive balance sheet. The Fed moved up the end of its asset purchase program from June to March at its last meeting and is expected to allow its balance sheet to begin shrinking later this year.

Some within the Fed would like to allow mortgage-backed securities to roll off the balance sheet faster than Treasury bonds. The bulk of the participants at the meeting prefer a more balanced roll-off of securities. We expect the Fed to reduce its balance sheet by $100 billion a month starting sometime this summer.

Most in financial markets are expecting the Fed to begin reducing its balance sheet in September. There is a push within the Fed to leverage reductions in the balance sheet to limit the number of rate hikes the Fed must complete in 2022. Our bet is that it moves sooner than most expect to reduce the balance sheet, in the hope that will allow a more orderly rise in rates.

Like it or not, the Federal Reserve is the de facto central bank to the world. Rate hikes in the U.S. will need to be matched with rate hikes elsewhere. Developing economies in particular will need to match rate hikes here with rate hikes of their own to defend the value of their currencies and prevent an unwanted, currency-driven rise in inflation. That makes the mountains of debt incurred during the pandemic even more expensive to service and ups the risk of a sovereign default.

The Fed is keenly aware of those risks. There is no Las Vegas in the global economy. What happens abroad will wash up on our shores. In response, the Fed is more mindful than it once was on how its decisions affect other economies. That is one of many reasons the Fed will be looking at ways to leverage the power of its balance sheet as well as shifts in short-term rates when it considers policy shifts.

The Fed has pivoted from being patient to panicked on inflation in record time. It took less than two months to pivot. Members who are now rotating into voting positions on policy decisions tend to be among the most outspoken on rate hikes. They will be pushing for even more aggressive hikes than their colleagues. Brace for dissents as debate about the pace of rate hikes intensifies.

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