The policy objective at Wednesday’s meeting of the Federal Open Market Committee will be to prepare market participants for the major shift in policy that lies ahead: a rate hike in March, another in June, and a balance sheet runoff likely to start in June or July.
Policymakers and investors should anticipate no change in the policy rate but should anticipate a policy statement and news conference that intend to shape expectations.
The key objective is for the Federal Reserve to lock in expectations for the next six months and to lay out what will most likely happen over the remainder of the year. This would imply that the news conference will be just as or more important than the policy statement.
While there is much talk of a surprise 50 basis-point hike—too much and irresponsible in our estimation—we now expect three 25 basis-point rate hikes this year with the chance of a fourth. In addition, we expect a roll-off of the Fed’s balance sheet, which currently stands at nearly $9 trillion, over the next three years that will approach $3 trillion but not feature any selling of assets.
This is a major risk event for market, and the Fed will need to follow up the meeting with carefully crafted rhetoric to define what they are doing, explain it to the public and lay out a direction that is both gradual and orderly during a time when the risk from inflation is rising.
The major changes to the statement will revolve around the idea that full employment is close at hand, requiring an adjustment in policy. In the Fed’s December statement, guidance on the pace of potential tightening was removed and it will not reappear anytime soon
The major changes to the Fed’s policy statement will revolve around the idea that full employment is close at hand.
The initial paragraph of the statement will most likely be altered to reflect the recent slowdown in economic activity because of the omicron variant. There is little chance that risk to the outlook from the public health crisis will be dropped.
Finally, we do not anticipate any change—primarily because of the disruption to economic activity caused by the omicron variant—to alter the pace in the reduction of Fed asset purchases, which is on a $60 billion per month pace, up from $30 billion.
While we acknowledge the case for speeding up the end of the asset purchase program, there has been no signal by the Fed that it is planning to do so. For this reason, we expect the status quo to remain as the central bank focuses on preparing the public, policymakers and market participants for a major change.
The news conference
Federal Reserve Chairman Jerome Powell will almost surely use the news conference on Wednesday to lay the groundwork for policy normalization, which in this cycle will mean rate hikes and a reduction in the balance sheet.
Market participants have priced in four full rate hikes this year with the probability of a fifth rising. While we think this is premature, Powell will have the opportunity to address this possibility.
In addition, given the arrival of three new potential appointees to the Fed’s board over the next three to four months, the FOMC will become more dovish, and Powell will certainly be asked about personnel.
He will also face uncomfortable questions around the recent stock selling scandals that have plagued the Fed, as well as direct questions on how the Fed intends to use its wide range of tools to address rising inflation.
While we do not expect a full discussion of how the Fed intends to draw down its balance sheet. Powell would be wise to begin providing a framework about what that looks like.
He may want to start with a reminder of how the Fed proceeded between 2017 and 2019, when it did a similar reduction. During that period, the central bank capped the amount of maturing assets allowed to roll off its balance sheet to $50 billion per month—$30 billion in Treasury bonds and $20 billion in mortgage-backed securities. Given the almost $9 trillion on the Fed’s balance sheet today, that will almost surely double once that policy gets underway.