The Federal Reserve this week faces the monumental challenge of starting to undo its massive economic help at a time when conditions are far from ideal.
In the face of a geopolitical crisis in Ukraine, an economy that is off to a slow start and a stock market in a state of tumult, the Fed is widely expected to start raising interest rates following the conclusion Wednesday of its two-day meeting.
Those three elements pose a dauting challenge, but it’s soaring inflation that the Fed will focus on most when its meeting starts Tuesday.
“The economic outlook supports the Fed’s current plans to boost the federal funds rate in March and to begin to reduce their balance sheet over the summer,” wrote David Kelly, chief global strategist for JPMorgan Funds. “However, there [are] a number of areas of uncertainty which should make them a little more cautious in tightening.”
However, the Federal Open Market Committee meeting will be about more than a solitary interest rate hike. There also will be adjustments to the economic outlook, projections for the future path of rates, and likely a discussion about when the Fed can start reducing its bond portfolio holdings.
Here’s a quick look at how each will play out, according to the prevailing Wall Street view:
Markets have no doubt the Fed will enact a quarter-percentage-point, or 25 basis-point, increase at this meeting. Because the central bank generally doesn’t like to surprise markets, that’s almost certainly what will happen.
Where the committee goes from there, however, is hard to tell. Members will update their projections through the “dot plot” — a grid in which each official gets one dot to show where they think rates will go in 2022, the following two years and then the longer range.
“The 25 is a given. What matters most is what comes after,” said Simona Mocuta, chief economist at State Street Global Advisors. “A lot can happen between now and the end of the year. The uncertainty is super-high. The trade-offs have worsened considerably.”
Current pricing indicates the equivalent of seven total increases this year — or one at each meeting — a pace Mocut thinks is too aggressive. However, traders are split evenly over whether the FOMC will hike by 25 or 50 basis points in May should inflation — currently at its highest level since the early 1980s — continue to push higher.
From a market perspective, the key assessment will be whether the hike is “dovish” — indicative of a cautious path ahead — or “hawkish,” in which officials signal that they are determined to keep raising rates to fight inflation even if there are some adverse effects on growth.
“We think the message around the rate hike has to be at least somewhat hawkish. The real question is whether the Fed is carefully hawkish or aggressively hawkish, and whether the meeting springs any surprises or not,” wrote Krishna Guha, head of central bank strategy for Evercore ISI. “Our call is that the Fed will be carefully hawkish and will avoid springing any surprises that might add to uncertainty and volatility.”
Regardless of exactly how it goes, the dot plot will see substantial revisions from the last update three months ago, in which members penciled in just three hikes this year and about six more over the next two years. The longer-run, or terminal rate, also could get boosted up from the 2.5% indication.
The economic and inflation outlook
The dot plot is part of the Summary of Economic Projections, a table updated quarterly that also includes rough estimates for unemployment, gross domestic product and inflation.
In December, the committee’s median expectation for inflation, as gauged by its core preferred personal consumption expenditures price index, pointed to inflation in 2022 running at a 2.7% pace. That figure obviously vastly underestimated the trajectory of inflation, which by February’s core PCE reading is up 5.2% from a year ago.
Wall Street economists expect the new inflation outlook to bump up the full-year estimate to about 4%, though gains in subsequent years are expected to move little from December’s respective projections of 2.3% and 2.1%.
Still, the sharp upward revision to the 2022 figure “should keep Fed officials focused on the need to respond to too-high inflation with tighter policy settings, especially against a backdrop of strong (if now more uncertain) growth and an historically tight labor market,” Citigroup economist Andrew Hollenhorst wrote in a Monday note.
Economists figure there also will be adjustments to this year’s outlook for GDP, which could be slowed by the war in Ukraine, explosive inflation and tightening in financial conditions. December’s SEP pointed to GDP growth of 4% this year; Goldman Sachs recently lowered its full-year outlook to just 2.9%. The Atlanta Fed’s GDPNow gauge is tracking first-quarter growth of just 0.5%.
“The war has pushed the Fed staff’s geopolitical risk index to the highest level since the Iraq War,” Goldman economist David Mericle said in a note over the weekend. “It has already raised food and energy prices and it threatens to create new supply chain disruptions as well.”
The Fed’s December projection for unemployment this year was 3.5%, which could be tweaked lower considering the February rate was 3.8%.
The balance sheet
Outside the questions over rates, inflation and growth, the Fed also is expected to discuss when it will start paring the bond holdings on its nearly $9 trillion balance sheet. To be sure, the Fed is not expected to take any firm action on this issue after this meeting.
The bond-buying program, sometimes called quantitative easing, will wind down this month with a final round of $16.5 billion in mortgage-backed securities purchases. As that ends, the FOMC will start to chart the way it will allow the holdings to start reducing, a program sometimes conversely called quantitative tightening.
“Balance sheet reduction will likely be discussed but increased uncertainty makes us think formal normalization principles will be announced in May or June,” Citi’s Hollenhorst said.
Most Wall Street estimates figure the Fed will allow about $100 billion in bond proceeds to roll off, rather than being reinvested in new bonds as is currently the case. That process is expected to start in the summer, and Fed Chairman Jerome Powell likely will be asked to address it during his post-meeting news conference.
Powell’s Q&A with the press sometimes moves markets more than the actual post-meeting statement. Mocuta, the State Street economist, said that given Fed policy acts with a lag, generally considered to be six months to a year, Powell should focus more on the future rather than the present.
“The question remains, where are you going to be in the middle of 2023?” she said. “How is inflation, how is growth going to look then? This is the reason I think the Fed should be more dovish, and should communicate that.”