Can the Federal Reserve truly be “nimble,” “flexible” and “adaptable”, or is it simply too big?
That is now the most pressing question for traders in 2022. After the US central bank said on Jan 26 that increasing interest rates “will soon be appropriate,” Chair Jerome Powell bluntly acknowledged the phrase means that a hike from the current range of 0% to 0.25% is coming after its next gathering. “I would say that the committee is of a mind to raise the federal funds rate at the March meeting,” he said.
Markets have been whipped into a frenzy in the weeks leading up to this policy decision. In early January, US Treasury yields soared as bond traders rushed to price in at least three quarter-point rate increases in 2022 and an expedited start to the Fed’s balance-sheet runoff. By the time central bankers entered their self-imposed blackout period, short-term rates traders were betting on four increases this year, and some investors floated the idea of a 50-basis-point move in March.
Powell did little to aggressively quash those more hawkish calls in his press conference. “I think there’s quite a bit of room to raise interest rates without threatening the labour market,” he said, electing not to entirely rule out the possibility of rate increases at every Federal Open Market Committee meeting from here on out. Powell also added that he doesn’t necessarily see balance-sheet runoff as a substitute for increasing its key lending benchmark.
At the end of the day, however, all anyone can say for sure is that the Fed will start tightening monetary policy in March and go from there. That was enough for bond traders to double down on their hawkish impulses. The two-year US Treasury yield jumped 14 basis points, the most since March 2020, to 1.16%; the five-year yield surged by more than 13 basis points to 1.69%; and the benchmark 10-year yield climbed about 10 basis points to 1.87%, near the intraday high set a week ago.
In a revealing answer at the end of his press conference, Powell admitted: “I don’t think it’s possible to say exactly how this is going to go, and we’re going to need to be nimble about this.” He added, as he said throughout the discussion, that “the economy is quite different this time.”
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Going Up
The difference, of course, is inflation that is running at the fastest pace in decades and unlikely to get much better for the Fed anytime soon. The central bank’s preferred measure of price growth, the core personal consumption expenditures (PCE) index, probably increased 4.8% in December from a year earlier, the most since 1983, according to a Bloomberg survey of economists. The PCE measure that includes food and energy costs likely jumped by 5.8%.
Meanwhile, Commerce Secretary Gina Raimondo said on Jan 25 that global chip shortages are likely to persist through 2022 in a blow to Powell’s hopes that supply constraints will soon ease and allow the Fed to more slowly tighten monetary policy. That puts the responsibility squarely on the Fed to start addressing the demand side of the inflation equation, starting in March.
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This answer to a question from my Bloomberg colleague Craig Torres summarises how Powell now sees things: “We need to be in a position with our monetary policy to address all of the plausible outcomes. We have an expectation about the way the economy will evolve, but we’ve got to be in a position to address different outcomes, including the one where inflation remains higher. Of course, that is a risk to the expansion. What we need here is another long expansion. In the record-long expansion, we saw labour-force participation rise, we saw wages persistently higher for people at the lower end, and there really was no obvious imbalance that threatened that expansion. It could have gone on for years were it not hit by the pandemic. We’d love to find a way to get back to that. That’s going to require price stability, and that’s going to require the Fed to tighten interest-rate policy and do our part in getting inflation back down to our 2% goal.”
I’ve called this philosophy around tightening monetary policy “benevolent rate hikes” — gradually removing accommodation now with the intent of bringing inflation back toward 2% and prolonging job gains. It’s better than the alternative: letting price growth become so entrenched that officials must slam the brakes on the economy.
Still, it is an open question whether the Fed’s projected path of interest-rate increases will be enough. The central bank had used the word “gradual” to describe its tightening campaign last time around, which amounted to roughly one quarter-point increase per quarter. Powell notably declined to use such a term this time. That is because, to use his phrase, there is a clear “imbalance” in the economy that the Biden administration has tasked the Fed with getting under control.
Curiously, Powell hinted at the prospect of a wage-price spiral that could keep inflation persistently elevated — a risk that central bank officials have typically tried to play down. “Price increases have now spread to a broader range of goods and services,” he said. “Wages have also risen briskly, and we are attentive to the risks that persistent real wage growth in excess of productivity could put upward pressure on inflation,” he added, before noting that like most forecasters, the central bank sees year-over-year inflation declining this year.
More than any time in recent memory, there is tremendous uncertainty radiating from the Eccles building. “We’re going to have to adapt and we’re going to communicate as clearly as we can,” Powell said.
The Fed has mighty tools at its disposal, but they are clunky at best. If inflation remains near the highest levels in decades, it can pencil in a fourth interest-rate increase to its dot plot in March or perhaps make clear that starting the balance-sheet runoff is imminent. But the one thing you learn from following the Fed is that this is a drawn-out process: First, a parade of policy makers must make public statements hinting at such a shift, then markets have to get the right message, then Powell or the FOMC minutes must confirm it. The whole pomp and circumstance does not lend itself to being nimble and adaptable.
If traders are nervous that the Fed’s strategy is to simply hope for the best this year, they are not yet showing it. But if it was not already clear, Powell does not have any room to accommodate the stock market’s tantrums. The tightening cycle is about to begin, and no one — not even the most powerful central bank in the world — knows how it will go. — Bloomberg Opinion
Photo: Jerome Powell, chairman of the US Fed / Bloomberg
