The Federal Open Market Committee (FOMC) left its target interest rate unchanged at this week’s policy meeting, with the range remaining at 0.00% to –0.25%. The central bank also confirmed that its quantitative easing (QE) purchases will expire in March. Those results were largely expected.
Despite not taking any unexpected actions, the Fed nonetheless surprised the market with the extent of its hawkishness. In his press conference, Fed Chair Jerome Powell was very clear that interest-rate hikes are imminent, that the scope for rate hikes is sizable and that the Fed will start moving quickly to pare down the size of its balance sheet.
Here’s a brief summary of the FOMC’s January 26 message:
- A March policy rate hike is all but certain.
- Rate hikes at every FOMC meeting thereafter haven’t been ruled out, nor has hiking rates by more than 25 basis points (b.p.) at a time.
- The labor market is strong enough to withstand multiple hikes.
- The equity sell-off hasn’t raised alarms or changed the central bank’s thinking.
- Balance-sheet reduction will start quickly, shrinking faster and by a bigger amount than the last time around.
That’s a clean sweep for hawkish signals. The notion that the FOMC would send them all at once would have been outlandish a few months ago; today, it’s not even particularly surprising. Short of raising rates at the January meeting, we’re not sure what else the committee could have done to convey that the policy setting will be dramatically different for the next few months than we’ve become accustomed to.
The next step for the Fed will be to follow through on this week’s rhetorical turn with concrete policy action. Lest there be any lingering uncertainty about that, Chair Powell said that “the committee is of a mind to raise rates in March” unless circumstances change. That’s unusually explicit for the Fed—and not by accident. A March hike is all but certain, but Powell refused to commit to a particular size or pace for rate hikes, leaving the door open for larger or more frequent rate hikes, if needed.
The advance toward tighter policy has started—and if the inflation picture worsens, the advance could become more of a sprint than a brisk walk.
The Labor and Financial Market Dimension
Even beyond the start date of the tightening cycle, Powell’s comments on how the cycle will play out were hawkish. He indicated that “there is plenty of room to raise rates without threatening the labor market.” The impediment to raising rates has been concern about the labor market not being at full employment, so stating plainly that labor is not only strong but strong enough to withstand multiple rate hikes sends a clear signal that multiple rate hikes are on the way.
Powell was asked whether the recent volatility in financial markets has impacted the FOMC’s thinking. His answer was that the Fed doesn’t watch any one market—it monitors a range of markets for signs of a persistent change in financial conditions. Powell is pleased with how the Fed/markets feedback loop is working, with financial markets adjusting to changing expectations around policy.
That doesn’t necessarily mean that the Fed wants equity markets to decline, but it does imply that the central bank isn’t worried about it right now. We do believe that there’s a Fed “put” on the equity market that would lead it to step in at some point if losses accelerate, but that point is likely far from where markets are now. In our view, it would take a very large sustained decline in the equity market to knock the Fed off course.
Plotting the Fed’s Near-Term Rate Path
Our strongly held base case is that the FOMC will start with a 25 b.p. rate hike in March followed by a June hike. If it feels an urgency to move more aggressively, we believe there will be another 25 b.p. move in May, rather than a 50 b.p. hike in March. The Fed will want to move gradually to gauge the economic and market responses before experimenting with larger moves, particularly early in the tightening cycle.
We expect another rate hike in September, after which the situation becomes much more uncertain. If inflation comes down and economic growth slows, as we expect, the FOMC will likely pause rate hikes later in the year. If inflation doesn’t cool off, the central bank will continue hiking until the economic situation changes.
Paring the Balance Sheet: Sooner, Not Later
Markets are also keenly interested in the Fed’s game plan for its sizable balance sheet. In the short term, it will wind down QE, with the last purchases in early March. Shortly after that, it will pivot from balance-sheet expansion to balance-sheet reduction.
The Fed released a statement of principles that will guide balance-sheet reduction. It’s quite general, containing no information on when the central bank will start reducing the balance sheet—nor how fast. But releasing the statement this week sends a strong message that the process will start sooner rather than later—the gap between the first rate hike and the start of the balance sheet run-off will be months, not quarters.
The principles make it clear that the process is meant to be predictable, so more details are coming before it kicks off. That’s why we continue to view July as the most probable start date, likely announced alongside a June rate hike. Once the Fed starts reducing the balance sheet, it will likely happen faster than in the last cycle, given the US economy’s stronger position. And with the balance sheet much bigger than it was in the 2015 to 2019 cycle, both in outright terms and as a percentage of gross domestic product, the reduction will go farther.
To sum things up, the Fed has pivoted fast and hard. The next few months will see a steady march toward tighter monetary policy…unless the inflation picture deteriorates further. And if that happens, the brisk walk will turn into more of a sprint.
- Eric Winograd
- Senior Economist—Fixed Income