What the Fed will and will not do
The Fed will confirm its aggressive stance, likely a reduction in the stock of government bonds from the third quarter. The comment by Paolo Zanghieri, senior economist of Generali Investments
Since the December meeting, the economy has continued to improve but inflation has proved more stubborn and more widespread than expected. Also, earlier this month, in his confirmation speech, President Powell explicitly stated that persistently high inflation could hamper achieving full employment.
This echoes warnings from several FOMC members, suggesting more than the three increases planned for 2022 at the December meeting may be needed. Current market valuations are priced slightly above the scenario of four rate hikes this year.
Without a rapid fall in inflation in the spring, a combination of four rate hikes and the start of a quantitative tightening – the reduction of bond positions – will be required.
As a result, we expect Powell to strongly suggest that the first rate hike will take place as early as March. Only bad January labor market data and / or a surprisingly rapid and substantial tightening of financial conditions next week would cause the Fed to delay the first rate hike.
A more decisive intervention on rates was hypothesized, ie a 50 bps increase, aimed at demonstrating a strong determination to fight inflation.
We believe that scenario is highly unlikely, as hikes at the expected rate of 25bps allow the Fed the flexibility it needs given the uncertain economic outlook. Furthermore, a sharp rise in policy rates could lead to an unwanted tightening of financial conditions.
There may be more information on how and how quickly the Fed will reduce its balance sheet, but not a full disclosure of the details.
In December, Powell said quantitative tightening would begin earlier and faster than the last episode; later several FOMC members reiterated this, without providing much additional information on what "faster and faster" means. This Wednesday, Powell could begin discussing possible scenarios to drive expectations.
Yet many questions are likely to remain unanswered, such as limits on the amount of non-reinvested bonds, the ability to sell assets as well as not reinvest maturing bonds, and how the composition of the Fed's balance sheet will change in the process.
We expect the quantitative tightening to begin in the third quarter after two rate hikes, and therefore the May meeting will be a good time for the Fed to spell out the details.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/che-cosa-fara-e-non-fara-la-fed/ on Tue, 25 Jan 2022 08:40:50 +0000.