Market Views from the Global Fixed Income, Currency & Commodities (GFICC) group

The Federal Open Market Committee (FOMC) voted to maintain the current Fed Funds rate at the zero lower bound (0.00%–0.25%) and signaled that rate hikes would soon become appropriate. There was no change to the pace of quantitative easing (QE) taper, which remains on track to end in March. 

Committee Statement

• Economic Assessment – The economic assessment was brief and positive. The opening line reflecting their commitment to support the economy in this “challenging time” was removed, suggesting we have moved further away from the immediate emergency. Inflation remains well above their target of 2% due to supply and demand imbalances; the labor market is strong.   

• Outlook – The Fed continues to view the path of the economy as dependent on the course of the COVID-19 virus (and variants), as well as the ongoing supply constraints and their ripple effects on economic activity, employment, and inflation.

• Current Policy and Forward Guidance –
  • The Fed made no change to their QE schedule. They will continue to reduce the pace of purchases down to USD 20 billion of Treasuries and USD 10 billion of Agency MBS from February 15^th through March 15^th, and this will conclude the taper. Balance sheet reduction is not expected until after the first rate hike.
  • On the timing of rate hikes, the Committee now expects rate hikes will be appropriate “soon” given the progress the economy has made toward maximum employment and the current levels of inflation.
  • Alongside the statement, they released a document including principles for reducing the size of the Fed’s balance sheet. The key takeaways were that the balance sheet would remain a secondary policy tool (the Fed Funds rate being the primary tool) and that balance sheet reduction would begin after the rate hiking cycle starts.  In addition, adjustments would be predictable, driven by the Fed’s dual mandate and adjusted primarily via reinvestments of principal payments. 

Chair’s Press Conference

At the press conference, Chair Powell reinforced the growing market consensus that a number of rate hikes and balance sheet normalization are necessary in 2022 to manage high inflation and a strong labor market.

• Labor market: The Chairman views the progress in the jobs market as “remarkable” and nearly consistent with full employment, although he remains optimistic that the level of maximum employment may increase over time. He sees large wage increases and a shortage of workers as a sign that the labor market strength will persist.

• Inflation: Chair Powell identified a number of factors that should support a decline in inflation, including the fact that fiscal and monetary policy will provide less of an impulse and supply chains should improve. The balance of risks to inflation remains to the upside and this is a threat to the expansion. He judged that his own forecast for core PCE would need to be revised upward compared to his last estimate at the December SEP.

• Rate Hikes: Chair Powell's comments defined ‘soon’ as the March meeting and that futures hikes would be data dependent. He said that the Fed needs to stay “nimble” and “humble” on the future path of monetary policy. He expects to move “steadily” away from the highly accommodative policy stance but believes that there is room to raise rates without threatening the labor market. He observed that the economy is significantly stronger than during the last normalization cycle and it could result in a different path for interest rates.

• Balance Sheet: The Chairman indicated the FOMC continues to have discussions about balance sheet normalization. They have created a framework of broad principles, but no decisions have been made on the timing or pace. He emphasized that interest rates remain the active tool of monetary policy and that the decline in balance sheet size will be orderly and predictable.

Our View:

• Shelter and wage inflation are showing enough signs of persistence that even after transitory factors fade, it is becoming increasingly clear that inflation will remain far above the Fed’s mandate for longer than previously expected, and when it does moderate, it will likely be at levels that remain above 2% on Core PCE.

• Given the robust inflation and labor market backdrop, we believe the Fed will hike rates at least 4 times in 2022 starting in March. We expect that they will continue hiking rates until they reach a mid-point of 2.375% (the high in the last cycle), which they should reach by Q1 2024 if they continue at a quarterly pace. We also expect the Fed to develop a balance sheet normalization plan by mid-year and begin the rundown by Q3 at a pace that could shrink the balance sheet through reinvestment caps at a pace of approximately USD 1 trillion per year.

• U.S. Treasury yields should be biased higher as a result of continued robust nominal growth and the Fed’s removal of policy accommodation. We expect the 10-year U.S. Treasury yield to rise to a range of 1.875%–2.375% by mid-year 2022.

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