The Federal Reserve should raise rates, but unique challenges could slow its pace

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U.S. Federal Reserve Board Chairman Jerome Powell speaks during his hearing on Senate Banking, Housing, and Urban Affairs Committee renominations on Capitol Hill in Washington, U.S., on January 11, 2022.

Graeme Jennings | Reuters

The Federal Reserve is expected to raise interest rates by a quarter point on Wednesday, a major step to reverse the extraordinary easing it implemented two years ago to help the economy through the pandemic.

Fed watchers expect the central bank to also provide a new quarterly forecast that could show as many as five or six quarter-point hikes this year, and possibly three or four more in 2023. The Fed’s tone may also sound hawkish, meaning it will emphasize that it intends to keep raising interest rates to fight inflation.

This time, the central bank faces unique issues that it did not see several months ago. Economists say there are growing risks that the Fed may not be able to raise rates as much as it would like.

Russia’s invasion of Ukraine has worsened already high inflation and created more risks to economic growth. Additionally, the pandemic has subsided in most of the United States, but is raging in China, where lockdowns threaten more supply chain disruptions and slower growth.

“There’s a dark cloud of uncertainty surrounding this meeting, but at the end of the day they know they’re down to zero,” said Jim Caron, the team’s chief fixed income strategist. Global Fixed Income at Morgan Stanley Investment Management.

“The economy is quickly reaching full employment and inflation is far too high,” he added. “You add it all up and that means they have to raise rates. The degree of uncertainty is extraordinary. They told us what they were going to do. They did it to get rid of the uncertainty.”

Fed Chairman Jerome Powell was blunt, guiding expectations about the timing and magnitude of the first rate hike when he testified before Congress earlier this month.

When the pandemic hit, the Fed quickly raised its zero federal funds rate target range to 0.25% in early 2020. It also launched a number of programs to add liquidity, including the Fed Funds Program. quantitative easing to buy treasury bills and mortgage bonds that it is just ended this month.

With headline consumer inflation at 7.9% in February, some economists believe the Fed is starting well behind the curve in its fight against inflation. Treasury yields have risen rapidly as market pros position themselves for higher inflation and Fed rate hikes. The 10-year Treasury yield was 2.12% on Tuesday, after touching 2.14% on Monday, its highest level since July 2019. Yields move opposite to prices.

“I think the world has really changed with this war and [it] would have been inflation that would have diminished by the middle of this year. It would have come down to more normalized levels,” said Rick Rieder, global fixed income investment director at BlackRock. “The impact on energy, commodities and food is real. I just think it really changed the inflationary paradigm to be much worse.”

The Fed also raises rates during times of financial market turmoil. Stocks slipped on uncertainty around Ukraine and concerns about rising interest rates. Oil prices surged, hitting $130 a barrel last week before falling back to around $97 a barrel on Tuesday for West Texas Intermediate crude futures.

“It complicates things because they are starting from scratch. I suspect financial conditions will tighten significantly and do some of the work for the Fed,” said Mark Zandi, chief economist at Moody’s Analytics. “The Fed is desperately trying to balance things out and avoid going into a recession. It really depends on what happens with the stock market, credit spreads, sentiment…and whatever other geopolitical issues come up. .”

Zandi said he does not expect a recession, but the odds have risen to 1 in 3 over the next 12 to 18 months.

“The Fed’s immediate reaction is going to be to fight inflation, but ultimately it has to consider slower growth due to higher oil prices,” Moody’s Zandi said. “It’s an important and unique aspect, but at the same time we have to put this into context, the Fed is already behind the game.”

Fed Forecast

The Fed will release new growth and inflation forecasts, in addition to interest rates. The central bank’s so-called “dot chart” is a chart that shows where Fed officials expect interest rates to be.

“I think they’re going to significantly degrade GDP. They’re going to raise inflation significantly, and more people will be talking about stagflation. But I think the US economy, consumption…and businesses are still in a pretty good shape. I think talking about a recession is very premature, but talking about a major economic downturn is not only not premature, but I think it should be the base case,” Rieder said.

BlackRock expects the Fed’s projections to now show gross domestic product growth at a pace of 2.8% in 2022, down from 4% in its December forecast.

Morgan Stanley’s Caron said he expects the Fed to raise its consensus forecast to signal that headline consumer price inflation could be between 4% and 5%. In the central bank’s projections, it uses a different measure and currently projects personal consumption expenditure inflation at 2.7% for 2022. Caron said that could reach 3% or more.

“They’re going to be warmongers by definition, but there’s a danger. I already expect them to put in the dot chart they do five to six times, and even some people would say that’s not not enough,” Caron said.

Bank of America’s Mark Cabana said the market could beat some of the forecasts because the outlook has become so uncertain. “We don’t think the market will care that much. The market led the Fed,” he said.

The Fed’s asset purchase program has helped boost the central bank’s balance sheet to nearly $9 trillion, and the central bank could provide some guidance on when it will start ending that program . The consensus on Wall Street is that the Fed will begin to reduce the balance sheet in June, but with growing uncertainty, that is now something that could eventually change.

Cabana said he expects the Fed to provide more details on how it will unwind the balance sheet, which has more than doubled since the pandemic. The Fed could reduce its level of holdings by ceasing its practice of automatically replacing securities as they mature. The process is called “quantitative tightening” or “QT”.

“Whether they’re ready to flip the switch on QT in May is our base case, but we recognize there are risks that this will be skewed later,” Cabana said. He said that if the Fed decides to slow its tightening, it could delay the balance sheet before it stops raising interest rates.

Slow rate hikes?

Rieder said he expects the Fed to suspend some of the interest rate hikes planned for this year.

“I think they need to take a neutral position, and there’s no ambiguity that being easy and accommodating is the wrong position,” Rieder said. “You have to hit a 1% funding rate, then let’s say you get there in late spring, early summer, and then you have to assess a slowing economy.”

“I think the midpoints are going to be between five and six ups this year, and I don’t think they’re going to factor that in,” he added.

Participants in a CNBC Fed survey predict the Fed will raise rates an average of 4.7 times this year. This would cause the federal funds rate to end the year at 1.4%. They expect it to be 2% by the end of 2023. Nearly half of respondents see the central bank increasing 5-7x this year.

The Fed is walking the political equivalent of a tightrope. If it doesn’t tighten enough, inflation will bring the economy down. If it tightens too much, it could slow the economy.

Reider said soaring inflation was already hurting the economy and that could be a problem for the Fed.

“You see the consumer sentiment numbers have really dropped dramatically,” he said.

“It puts the Fed in a position that makes its job much more difficult. I don’t think it speeds up the Fed. I think it will ultimately slow the Fed down,” Rieder added.

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