The Federal Reserve still has a lot of questions to answer about its long-term strategy

Image of the Federal Reserve Board building in Washington, U.S., March 19, 2019.

Leah Millis | Reuters

While the Federal Reserve has this week tried to clarify its short-term plans, there are still more than enough long-term questions to worry investors.

Markets initially react favorably to the Fed statement after Wednesday’s meeting, in which it said it would combat explosive inflation by accelerating a reduction in monthly bond purchases and possibly raising interest rates three times by 2022.

But Market action on Thursday less convincing, with interest-sensitive stocks plummeting and government bond yields, which could have been expected to rise as the Fed tightens, fell instead.

One reason for these moves, especially for bonds, is that the market may not fully believe the Fed can do what it has outlined in its future projections.

“The bigger challenge for the Fed and for the markets is that they may not be able to afford the rate hikes they say they are,” said Chief Executive Kathy Jones. fixed income strategist at Charles Schwab. “What the market is telling you is the Fed doesn’t have much scope to go through two or three hikes.”

On the way to hiking

Messages from “dot graph” of projections from the 18 members of the Federal Open Market Committee suggest that the Fed is prepared to go beyond just a few rallies.

Every member is involved in at least one rate hike in 2022, with two even going as far as indicating four hikes. A majority of members have seen the Fed pass three hikes by a quarter of a percentage point next year, followed by three more in 2023 and twice in 2024.

But Jones says that outlook may be too aggressive considering all the challenges facing the economy, from Pandemic is going on to demographic and labor force constraints that kept inflation and rates contained for more than a decade.

“Pushing rates up significantly can be quite difficult without causing a much tighter financial situation than they might like to see,” she said.

Limits on scaling can be dangerous Fed’s credibility as an anti-inflationist and caused many concerns about asset bubbles. Markets reacted strongly to Wednesday’s statement, sending stocks in a massive rally that both reflected relief that the FOMC’s statement was not overly aggressive on monetary policy while the range was tight tight Fed financial conditions are constrained.

With inflation is at a 39-year high, finding the right balance between price stability and economic support will be challenging.

“In our view, the Fed has lagged behind the curve since the start of the year and remains behind the curve today,” said Mark Cabana, head of interest rate strategy at the Bank of America. said in a note.

“The new Fed policy is very non-linear, creating a dangerous end-game,” Cabana added. “Once the Fed hits its targets, the Fed should take a neutral policy stance, not a super-stimulating zero-interest rate policy and a giant balance sheet. In our view, the Fed is basically achieved its goals.”

The road is tight ahead

Reducing the balance sheet is a completely different problem the Fed will face in the long term.

Chairperson Jerome Powell said at its post-meeting news conference that policymakers had just begun discussing how to eventually reduce holdings. That process should begin after the taper is over, and at least possibly until the Fed has a few rate hikes in the near-term.

However, there is another component and potential complication as the Fed is trying to engineer a soft landing from monetary policy that has been adjusted to an unprecedented degree. Last time, from 2017 to 2019, “quantitative tightening”, as it is known, did not end well, with markets revolting after Powell said the process was on “autopilot”. ” at a time when the US economy is weakening.

It’s all what Krishna Guha, head of global policy and central banking strategy at Evercore ISI, calls “Powell’s conundrum” of reducing inflation while supporting an economy that is above through a challenging period.

“Relatively positive QT may be necessary if the Fed over time fails to gain traction towards the longer end of the yield curve and broader financial conditions,” Guha said in a note. “This is the most obvious of which the ‘Powell’ conundrum’ needs to be carefully considered by investors and may contain the seeds of its own destruction, although this has many implications. more to the timeline until 2022 and beyond, not for the next few weeks or even months.”

During this time, market travel could upset markets, especially after Fed officials returned to the public and began delivering one-off policy speeches. again. New York Fed President John Williams will be on CNBC’s “Squawk Box” on Friday at 8:30 a.m. ET.

“Going through anti-inflation moves, which is what we’re talking about, can cause quite a bit of volatility in the short term,” said Christopher Whalen, President of Whalen Global Advisors.

Still, Whalen expects the Fed to accept the markets if policy turns restrictive.

“The unwritten American truth is that we need inflation in this society to keep the political peace,” he said. “I’m not looking for much anti-inflation from this guy [Powell] because if the market disappears, he will fold very quickly. “ The Federal Reserve still has a lot of questions to answer about its long-term strategy


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