This Fed Meeting Is Crucial. Future Rate Hikes Are Just the Start.

To be sure, stock and bond markets have started 2022 by adjusting to the reality of a less accommodative Federal Reserve monetary policy ahead. The benchmark 10-year Treasury note’s yield is up 34 basis points since the turn of the year, at 1.836% on Thursday, while the Nasdaq Composite has entered a so-called 10% correction from its peak last November. And the federal-funds futures market has fully priced in an initial 25-basis-point increase in the Fed’s key policy rate, from the current ground-hugging 0% to 0.25%, at the March 15-16 FOMC gathering, according to the CME
FedWatch site. (A basis point is 1/100th of a percentage point.)

But no rate increase is likely this week, despite a growing consensus (including from President Joe Biden) on the need for a less accommodative Fed policy, given the sharp rise of inflation. At his news conference on Wednesday, Biden expressed support for Fed Chairman Jerome Powell’s plan to “recalibrate” policy. “The critical job of making sure that the elevated prices don’t become entrenched rests with the Federal Reserve, which has a dual mandate: full employment and stable prices,” the president said.

That’s a sharp reversal of the pressure often exerted by past presidents for easier money. From Lyndon B. Johnson to Nixon and Donald Trump, presidents have variously tried to cajole or coerce Fed chairmen into lower interest rates or avoid raising them, while George H.W. Bush blamed a too-tight Fed for his electoral defeat. But now, inflation’s surge to 7% tops the list of concerns in consumer surveys, coinciding with the slide in Biden’s poll ratings, so his endorsement of a less accommodative Fed policy appears to be a matter of political necessity.

So acute have inflation concerns become that some observers are urging more immediate and dramatic actions. That includes calls for a 50-basis-point jump in the fed-funds rate, as I wrote this past week on Barrons.com, or a complete halt in the Fed’s securities purchases, as I noted here a week ago, rather than the present path of winding down its buying by March.

But both would be out of character for the Powell Fed. “I can’t imagine another big pivot,” says John Ryding, chief economic advisor at Brean Capital. For most of 2021, the monetary authorities clung to the notion of “transitory” inflation. A sharp, initial 50-basis-point hike would be an admission of how they misjudged the building price pressures, he says.

Neither does Ryding look for the Fed to emulate the Bank of Canada, which abruptly ended its securities purchases last year. “What I hope to get is clarity” from the FOMC meeting in the coming week, he added in a telephone interview.

One possible surprise would be for the FOMC to further accelerate the tapering of the purchases, winding them up by mid-February, a month earlier than currently scheduled, write Nomura economists Aichi Amemiya, Robert Dent, and Kenny Lee in a client note. That would represent a marginal reduction of $20 billion in Treasury and $10 billion in agency mortgage-backed securities acquisitions, but would send a signal to the market about the Fed’s anti-inflation resolve.

As for the Fed beginning to normalize its balance sheet, the Nomura economists think the announcement could come as early as the March or May FOMC meeting. Most Fed watchers expect a later start to the process of reducing the central bank’s securities holdings, after two or more rate hikes. And almost all think the Fed will allow maturing issues to run off at a predictable pace, rather than sell securities outright.

Some also suggest that the Fed could reduce its holdings of mortgage-backed securities more rapidly. The Fed has expressed a preference to returning to holding only Treasuries on its balance sheet, as was the case before the 2007-09 financial crisis, Ryding notes. And for months, many critics have argued that effectively subsidizing an already overheated housing market by buying MBS makes no sense.

But the relative economic and financial impact of changes in these two main monetary policy tools—interest rates and the central bank’s asset holdings—is unknown, he says. The Fed traditionally has utilized the fed-funds rate as its main policy lever and resorted to a huge expansion in its balance sheet when its key policy rate fell to the zero lower bound. Unlike other central banks, notably the European Central Bank and the Bank of Japan the Fed has avoided resorting to negative interest rates.

Economists Cynthia Wu of Notre Dame and Fan Dora Xia of the Bank for International Settlements have estimated that the equivalent impact of the Fed’s asset purchases in what they dub a “shadow fed-funds rate,” which is tracked by the Atlanta Fed. The Wu-Xia shadow funds rate was minus 1.15% as of Dec. 31, according to the Atlanta Fed.

Ryding says Wu estimates that a change in the Fed’s balance sheet equal to 10% of U.S. gross domestic product—about $2 trillion—is roughly equivalent to a 100 basis point change in the fed-funds rate.

How central bank bond-buying affects the economy is still debated among economists. Most see asset purchases working through what they call the portfolio channel. As former Fed Chairman Ben Bernanke explained in a Washington Post op-ed article in November 2010, the central bank buys securities to ease financial conditions, including to raise stock prices, which in turn boosts consumers’ wealth and confidence, and spurs spending.