Federal Reserve expected to signal March interest rate hike — with more to come

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Clear communication from Fed officials about the pace at which it is tightening its monetary policy could help soothe a nervous Wall Street.

The Federal Reserve is widely expected to telegraph plans at its meeting this week that it is ready to start raising interest rates for the first time since 2017. 

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The central bank is likely to make the move in March, at the conclusion of its next policymaking meeting — and almost exactly two years to the day after it slashed rates to zero in response to the emergence of a fast-spreading novel coronavirus that threatened to destabilize the entire financial system. 

Fast-forward to 2022 and the macroeconomic climate has changed markedly: Today, the greatest economic worry for many is rapidly escalating prices of food, fuel, housing and a host of other goods and services.

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“It’s a very important meeting, because the next meeting is within six weeks, and the hawkish pivot from the Fed was quite substantial,” said David Norris, partner and head of U.S. credit at TwentyFour Asset Management. 

When conditions change quickly, it can leave the Fed playing catch-up — a position that gives Wall Street heartburn.

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Fed officials will release a policy statement Wednesday afternoon, followed by a press conference with Federal Reserve Chairman Jerome Powell. According to the CME’s FedWatch Tool, market participants expect a quarter-percentage-point (25-basis-point) rate hike at that March meeting with near-90 percent probability.

In addition to interest rates — its best-known policy tool — the Fed also kept monetary policy loose over the past two years by buying billions of dollars in Treasuries and mortgage-backed bonds every month, a process it has begun winding down. These purchases have nearly doubled the Fed’s balance sheet over the past two years, and Wall Street is also looking for Fed officials to offer guidance on when and how fast they will begin paring back the amount of those holdings, either by letting them drop off as they mature or by selling them.

“What took the market by surprise in December was the notion that they made quantitative tightening a near-term issue,” said Keith Buchanan, portfolio manager at Globalt Investments. “That introduced to the market the idea of those simultaneous measures, which set the stage for what we saw in January” — specifically, the dramatic market swings and elevated volatility as traders tried to game out the financial impact of policymakers growing more worried about inflation marring economic growth in 2022.

A slow trajectory is generally in keeping with the Fed’s measured, deliberate pace of monetary policy adjustment. As an institution, the central bank tends to adopt a long run-up of communication before taking action. But when conditions change quickly, this can leave the Fed playing catch-up — a position that gives Wall Street heartburn, and is one of the culprits market observers blame for the wild gyrations the major indices have undergone in recent days. 

“Historically, the Fed is really looking to calm markets… but calming markets after such an intense bout of volatility is going to be difficult,” Norris said. 

The Fed realized — too late, according to Norris — that the price inflation plaguing American businesses and consumers alike was both broader and longer-lasting than it had anticipated. 

“I would have liked to have seen the Fed announce an end to quantitative easing in the last quarter as well as begin starting to raise rates, just because they’re so far behind the curve and quite a long ways from neutral,” Norris said.

As such, some argue that initiating policy normalization won’t necessarily calm market jitters. “If they do indicate that they will begin tightening sooner than the market anticipates, that would indicate that they need to be more aggressive about stopping inflation — that would not be comforting,” Buchanan said. “The initiation of quantitative tightening sooner than the market expects would cause them to feel like the Federal Reserve is becoming desperate.” 

“It’s a tricky situation. You want to listen to the market, but you don’t want to cater to the market because you’ll just end up trying to please the investor population, and that leads to all sorts of negative consequences,” said Mike Zigmont, head of trading and research at Harvest Volatility Management. “You don’t want to be totally focused on making the market happy,” he said, since an overly accommodative stance that is out of sync with economic fundamentals can lead to asset bubbles.

Mona Mahajan, a senior investment strategist at Edward Jones, said that shrinking the Fed’s balance sheet will help unwind those kinds of distortions. “In removing liquidity from the system, where we’ve really seen that play out in markets is giving less air to the more speculative, higher valuation parts of the market,” she said.

The biggest key for the Fed is to show it is taking inflation seriously.

Even without a pandemic in the mix, the Fed has a delicate balancing act. “There’s a lot of other moving parts that are coming in to the discussion,” said Charlie Ripley, senior investment strategist for Allianz Investment Management. “Higher wages could continue to make inflation more persistent as we go through 2022.”

Markets today need reassurance that the Fed can and will take aim at inflation, lest it escalate further. “The big key for them is to say they’re taking this seriously,” Gillum said. 

A big part of the challenge is that the central bank is tasked with a dual mandate of achieving full employment and price stability (that is, low inflation) — and in circumstances such as the economy is facing today, there is tension between those two aims. 

The pandemic triggered the highest spike in the unemployment rate since the Great Depression and destroyed some 22 million jobs. While the employment picture has improved markedly since then, labor participation remains puzzlingly sluggish. Economists have identified a number of possible reasons, including disruptive school closures that have relegated many former workers to unpaid child care duties, a growing segment of the nation’s aging population opting for early retirement, higher personal savings rates that have given workers more flexibility in their job searches and lower levels of immigration. 

With so many potential workers sidelined, companies have been raising pay — which is good news for job-seekers but adds to the cost pressures companies are facing on top of supply chain bottlenecks.

“We think generally inflation is set to fall, but set to remain elevated compared to pre-pandemic trends,” Mahajan said. “We’re starting to see early signals that the supply chain disruptions may be starting to ease. Where we’re still watching for improvement is the labor shortages.”

“It’s going to be tough to engineer a soft landing,” Gillum said — but he also said that clear communication from Fed officials could help soothe a nervous Wall Street. “Rate hikes in and of themselves don’t mean equity markets are going to sell off, it just means that we’re mid-cycle. It doesn’t mean the economy’s on the brink of recession.”

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