The Federal Reserve is expected to take a huge step towards the first rate hike

Federal Reserve Chairman Jerome Powell attends a House Financial Services Committee hearing on Capitol Hill in Washington, U.S., September 30, 2021.

Al Drago | Reuters

The Federal Reserve is expected to announce a dramatic policy change on Wednesday that will clear the way for its first rate hike next year.

Markets are anticipating the Fed will accelerate its bond-buying program, changing the end date to March from June.

That would free the central bank to start raising rates from zero, and Fed officials are expected to issue a new forecast that suggests two to three rate hikes in 2022 and three to three. four more times in 2023. Before that, there was no consensus for a rate hike in 2022, though half of Fed officials expected at least one.

At the end of its two-day meeting on Wednesday afternoon, the central bank should also acknowledge that inflation is no longer the “transient” or temporary issue that officials have thought it to be, and that rising prices have could be a bigger threat to the economy. The consumer price index rose 6.8% in November and is likely to heat up again in December.

“I think the exit from the easing business is very much overdue,” said Rick Rieder, global head of fixed income investment at BlackRock.

The Fed adopted a quantitative easing program to combat the effects of the pandemic in early 2020, and it also cut the target interest rate on lending funds to zero.

Prepare the market

Fed officials in mid-November began discussing the idea of ​​a faster shrink, and they succeeded in turning market expectations around for a quicker end to $120 billion in bond purchases a month. Market expectations also increased about the timing of interest rate hikes from the end of next year to the beginning of June.

By ending bond purchases earlier, the Fed is giving itself the option of raising rates, Rieder said. “I think they could raise rates in 2022. I don’t think there’s a rush,” Rieder said.

He said the Fed could raise it twice by 2022 and three to four times by 2023.

“I think the data will determine when to start. I don’t think the Fed has any view that they have to start any quarter,” he said. Rieder said how the Fed will then be better able to handle persistent inflation and whether the virus continues to pose a risk to the global economy in the new year.

While the Fed is expected to sound hawkish, or in tightening mode, Fed Chair Jerome Powell could be listening much worse when he speaks to the press at 2:30 p.m. ET Wednesday, 30 minutes after the central bank released its statement and forecast. .

“For them to be able to justify the taper speed increase, the FOMC statement has to be quite abrupt,” said Vince Reinhart, chief economist at Dreyfus & Mellon. Powell will likely discuss both hotter inflation, but also why the Fed may remain somewhat cautious.

“We’ve retired ‘temporarily’, but the transition seems like a big step because he’s made a quick transition,” Reinhart said. “He could take a moment to talk about the mutations of the virus and the risks to the outlook and what might happen.”

Accounting balance sheet

The big wild card for markets is what the Fed says about its balance sheet, which was $4.1 trillion in January 2020 before the pandemic but has grown to $8.7 trillion. As the securities on the balance sheet mature, the Fed replaces them, thus buying billions of dollars more in Treasuries each month.

“It would be a surprise to the market if he came out and said we don’t need to keep the scale at this level,” said Rieder. The Fed is more likely to reduce its balance sheet after raising rates, he said.

Still, the Fed’s balance sheet cuts can sometimes have a bigger impact on markets than rate hikes, he said.

Goldman Sachs economists have come up with a scenario for spillovers, which they say may be less conservative than the last cycle after the financial crisis. The runoff will begin if the Fed allows the securities to simply mature, and by not replacing them, the balance sheet will begin to shrink.

“We forecast that the fourth rate hike will come in 2023H1, and our best guess right now is that the inflows will start around that time. And inflation should be modest, at least much more than the rate hike we expected,” they wrote in a note. “However, markets have sometimes reacted strongly to past balance sheet reductions.”

Diane Swonk, chief economist at Grant Thornton, expects the Fed to discuss the balance sheet at this meeting but has yet to act.

“I think he will be questioned about the balance sheet,” Swonk said. “They’ve tried to get their balance sheet depleted before. That’s something we should expect to happen faster this time. I don’t think they made that decision… I wouldn’t be surprised to see that in the [meeting] minute.” The Federal Reserve is expected to take a huge step towards the first rate hike

Sarah Ridley

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