FOMC recap: a long way from neutral (again)
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The Federal Open Market Committee (FOMC) met this week and paved the way for further monetary policy tightening in the coming months. Their approach combines increases in the Federal Funds rate and balance sheet normalization, with quantitative easing (QE) ending in March and balance sheet runoff following shortly thereafter. A March rate hike is all but assured based on futures pricing, with three additional hikes and a 60% chance of a fifth hike priced in for 2022.
- The FOMC expects it will “soon be appropriate” to raise the Federal Funds rate, with markets pricing in a 100% probability of a rate hike in March.
- The Fed is now willing to move sooner and perhaps faster than the previous cycle normalization, which pulls forward the expectation of balance sheet runoff timing to any FOMC meeting after the anticipated March rate hike.
- Inflation is now well above the FOMC’s 2% target with CPI increasing 7% year-over-year in December 2021, and the labor market is strong with unemployment at 3.9%, the lowest level since February 2020.
- While statements on quantitative tightening were cautious (letting maturing bonds roll off the balance sheet instead of outright bond sales), Chair Powell has stated the Fed has “plenty of room to raise rates without threatening the labor market”.
- Powell did not shy away from, or outright shoot down, hawkish questions such as the possibility of a 50 basis point rate hike during the press conference.
Updated path of policy normalization
The Federal Reserve retired the word transitory from their inflation playbook in November 2021 and has since taken on a more hawkish stance. This week’s meeting reinforces that stance with the FOMC retaining discretion to deal with the uncertainty around high inflation by hiking rates and reducing/removing balance sheet accommodation. With the employment portion of the dual mandate arguably satisfied after the unemployment rate reached the best levels since before COVID-19, the Fed’s focus is now squarely on tightening monetary policy to rein in inflation without adversely impacting labor markets or putting too much pressure on overall financial conditions.
The meeting's major change was an end to quantitative easing by early March and an emphasis on rate hikes to start the tightening cycle with a high degree of flexibility subject to incoming data over the next few months.
Inflation has accelerated through 2021, driven by simultaneous supply and demand shocks. Entire supply chains were disrupted as nations locked down and closed their borders, while the fiscal and monetary stimulus taps were opened in full force. Consumers have been flush with cash and unable to spend it on travel or experiences, leading to an increase in the purchase of goods. The combination of this negative supply shock and positive demand shock has strained supply chains with the effects still being felt.
The trend in inflation over the next several months will be crucial in evaluating the Fed’s path for monetary tightening. With the Build Back Better stimulus bill on the backburner, peak fiscal stimulus now appears to be in the rearview mirror, which should pull down demand and relieve some supply chain pressure. Headline GDP for Q4 2021 grew at 6.9%. However, 4.9% of that number was due to changes in private inventories. If businesses are responding to supply chain issues by increasing inventory buffers, this should relieve some pressure once inventories are stocked up. If COVID-19 restrictions are eased as the omicron wave fizzles out, a shift toward travel and service consumption vs. goods consumption may also relieve these pressures.
Some global indicators are still flashing inflationary warning signs. Oil recently rose above $90 per barrel, a level not seen since 2014. The Bloomberg Commodity Spot Index (which contains a basket of 23 commodities) recently set an all-time high. China’s zero-COVID policy has shut down entire cities and ports after small outbreaks, which could further disrupt supply chains if they maintain this policy (particularly with the Beijing Olympics around the corner). Overall, divergent government reaction functions to COVID-19 outbreaks will continue to impact the resiliency of economic recoveries.
Headline unemployment has improved to 3.9%, which is the lowest level seen since February 2020. While the headline number would suggest full employment, some items under the surface do point to labor market slack. Labor force participation has seen a downward move since the COVID-19 pandemic began. The reason is unclear — are people not comfortable returning to work or did the pandemic pull forward a few years' worth of retirements? Unlike the 2008 crisis, home values and financial asset prices rebounded quickly during the pandemic, which, along with the significant disruption to the economy, may have nudged those close to retirement to leave the workforce. The prime-aged (25–54) labor force participation rate has rebounded to 81.9% but is still slightly below the 83.1% pre-pandemic rate.
Wage earnings have also increased with the labor market remaining extremely tight across the board. A tight labor market combined with high inflation and high inflation expectations could become embedded in prices via a wage price spiral. President Biden alluded to this in a January 19 press conference by calling on the Fed to “recalibrate the support that is now necessary … to make sure that elevated prices don’t become entrenched.” If financial conditions continue to tighten and asset prices fall, a reduced wealth effect may also lower the amount of people willing to depart the labor force or lead some people who are currently on the sidelines looking to re-enter the workforce.
Market reaction and looking forward
The initial market reaction to the FOMC meeting was a sharp increase in rates across the yield curve. Futures now price in a 100% chance of a 25 basis point March hike, with 26% odds of a more aggressive 50 basis point hike. The 10-year Treasury yield reached 1.85%, a level not seen since January 2020.
The shape of the Treasury curve has flattened in connection with the increase in short-term rates. The spread between 30-year and 5-year Treasuries is now below 50 basis points, which is the lowest spread seen since early 2019. While short-end rates show the market’s prediction of near-term Fed policy rates, curve steepness and long-term yields give us insight into the market’s view of how quickly the Fed can raise rates and how high rates can ultimately go. While rate hikes appear imminent for 2022, a flat yield curve with low long-term yields currently implies the rate hike cycle will fizzle out with rates around 2%.
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