Federal Reserve hawks will push for faster tapering, interest rate rises despite Omicron

Asia's Tech News Daily

new Covid-19 variant, faster interest rate increase, Omicron, US$15 billion per month, little market reaction, “transitory” inflation

Up until two weeks ago, the biggest fear for markets was runaway inflation and how aggressive central banks may become in containing it. However, news of a new Covid-19 variant has cast a shadow over economic growth, and is posing a bigger risk to global economic recovery.

But the trend is still for central banks, and particularly the US Federal Reserve, to continue to ease off the monetary accelerator. The growing chorus of Fed Reserve committee members calling for a faster interest rate increase has grown in recent weeks, emphasising the importance of the Fed’s next meeting later this month, and there is no certainty that Omicron has changed that.

A group of hawks is called a kettle. A kettle is often formed when hawks take advantage of warm thermal updrafts to climb higher into the sky. This is remarkably similar to the hawkish Fed committee members who are using the warming US economy and high inflation rates to rise above their fellow committee members in calling for a change to the interest rate outlook.

At the Fed’s meeting last month, committee members agreed to reduce the pace of bond purchases by US$15 billion per month and to review the need for further adjustments at the next meeting. In the last few weeks, there have been calls by committee members to accelerate the pace of stimulus tapering and bring forward the timing of the first interest rate increase, possibly to the middle of next year.

This makes sense as the Fed is unlikely to raise interest rates while still buying bonds, so would need to wrap up its latest quantitative easing programme sooner. Somewhat at odds with this has been the Fed’s stance that bond buying is separate from the path of policy rates, but clearly there is a sequence that must be followed of stimulus tapering then monetary tightening.

Although in its infancy, the tapering process has been rather successful as it created little market reaction before and after being announced. But it may become less smooth for markets if the Fed decides at its upcoming meeting to increase the pace of tapering, as this would signal that the Fed was setting up for an earlier start to interest rate hikes.

Federal Reserve chair Jerome Powell’s recent testimony to Congress also marked a shift in the “transitory” inflation view long held by the Fed.

This signalling effect is much greater than in any actual change to bond purchases. During the tapering process, the Fed is still pumping liquidity into the market but at a decreasing rate. For example, if the current tapering is doubled to US$30 billion per month starting in January, then the total value of US Treasuries and mortgage-backed securities that the Fed bought during the taper process would drop by US$135 billion. This may seem like a lot but isn’t when compared to the Fed’s total balance sheet of US$8 trillion.

The December 14-15 meeting is also one of the four meetings a year when the Fed releases its economic projections for the US economy as well as the so-called dot plot, a chart that shows when each committee member expects the central bank to change interest rates. The September dot plot showed that half the committee members were already forecasting at least one rate increase in 2022, and this number is only likely to increase at the coming meeting.

Getting in one interest rate increase by the end of next year is entirely plausible given the Fed is on track to fulfil both its inflation and full employment mandates. One interest rate increase is also in line with the gradual normalisation process that central banks are leaning into and the willingness to be behind the curve when it comes to the economy.

Two or more interest rate increases would be a departure from this well-used narrative and markets may have trouble digesting it if it raised fears that a more aggressive normalisation path could derail the positive economic growth story.

The Fed’s history of interest rate increase cycles shows that the market is often more aggressive in calling for the start and in predicting how fast rates will go up. This time is unlikely to be different.

While the momentum in the US economy and elevated rate of inflation could be used to justify a quicker return to a more neutral policy stance, the potential for Covid-19 to interrupt the recovery remains. The degree to which the Fed decides to quicken the pace of the taper is likely to depend on the risk assessment of health officials on the Omicron variant and the Fed’s take on any negative impact on the growth outlook. The Fed hawks may continue to ride the inflation thermals higher.

Kerry Craig is a global market strategist at JP Morgan Asset Management

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