Fed Leaves Gradualism Behind

In a bid to keep the U.S. economy from overheating amid high inflation and near-full employment, Federal Reserve officials are preparing to move more quickly than they did the last time they tightened monetary policy.

Prospects for another year of growth above the economy’s speed limit, with inflation already strong—along with a larger balance sheet that’s suppressing longer-term borrowing costs—“could warrant a potentially faster pace of policy rate normalization,” according to minutes from the December 14-15 Federal Open Market Committee (FOMC) meeting.

Financial markets interpreted the comments as unequivocally hawkish. Traders raised bets on an interest-rate hike as soon as March to around an 80 percent probability, while the S&P 500 stock index slumped by 1.9 percent at the close, the biggest drop in more than a month.

Officials also saw the timing of reducing the $8.8 trillion balance sheet as likely “closer to that of policy-rate liftoff than in the committee’s previous experience,” according to the minutes. JPMorgan Chase & Co. economists expect that process to begin in September.

The details of the Fed’s pivot toward more aggressively fighting inflation suggest it will show greater urgency and agility than the gradualism of the past. They also indicate a desire to smash market perceptions that the central bank is losing its grip on surging prices.

The 5.7 percent annual increase in the Fed’s preferred inflation gauge in November overshot officials’ 2 percent target for the ninth consecutive month, toppling their earlier predictions that prices would moderate as supply-chain issues resolved.

Meanwhile, a government report Friday is forecast to show the jobless rate fell in December to a new pandemic low of 4.1 percent—a figure near what Fed officials view as consistent with maximum employment.

“They are fighting a different battle on this exit,” said Priya Misra, global head of rates strategy at TD Securities in New York. “They are telling us why: It is inflation, and it is also that we are closer to full employment.”

Chair Jerome Powell and other officials are set to address the outlook over the next week, ahead of their January 25-26 meeting, where they could signal the likelihood of a March move. Policymakers have yet to give detailed remarks on how they view the impact from surging Covid-19 infections related to the omicron variant.

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What Bloomberg Economists say …

“The minutes showed the FOMC is coalescing around the view the economy is ready for a broad-based removal of monetary accommodation, and the omicron variant is unlikely to slow it down. We think the risk of rate liftoff at the March meeting has increased substantially, and will be watching closely Fedspeak ahead of the January meeting for further indications.”

— Anna Wong (economist)

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Over the past two decades, Fed tightening cycles have been gradual and predictable, starting with the stair-step “measured” pace increases of the 2000s. After the financial crisis, the Fed got off to a slow start as slumping international economies and too-low inflation—combined with an agonizing, jobless recovery—warranted caution. By 2018, however, the central bank was on steady, four-hikes-per-year pace.

“We are used to this highly telegraphed, quarter-point, very predictable” rate cycle, said Vincent Reinhart, a former head of the Fed’s division of monetary affairs. “Now we have an element of catching up, so they want to be seen as nimble.”

In practice, he said, that means potentially signaling that one rate hike could soon be followed by another at the subsequent meeting, without fully committing to it, said Reinhart, now the chief economist at Dreyfus and Mellon.

At the December meeting, Fed officials were anticipating three quarter-point hikes in 2022, according to the median in the central bank’s “dot plot.”

A formula developed by Bloomberg Economics, however, “strongly suggests that the anticipated path of the funds rate is more likely to be revised up than down,” former Fed economist David Wilcox, director of U.S. economic research at Bloomberg, wrote in a note Wednesday.

The meeting showed Fed officials received a briefing from staff members on issues related to normalization of the central bank’s balance sheet following trillions of dollars of bond-buying. During the last rate-hike cycle in the 2010s, the Fed waited almost two years after liftoff to begin trimming assets.

This time around, “participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the committee’s previous experience,” the minutes said.

In addition, “some participants judged that a significant amount of balance sheet shrinkage could be appropriate over the normalization process.”

The minutes did offer some clarity on how officials view maximum employment, the variable that will now determine the timing of rate liftoff. Apart from the headline unemployment rate, the committee has been debating whether labor supply—represented by the participation rate—could rebound as companies scramble for workers.

The participation rate for people in their prime working years was 81.8 percent in November, below the last expansion’s peak of 83 percent seen in January 2020.

The minutes said “a number” of officials judged that a full recovery in participation would take longer than expected—in effect signaling the economy was already close enough to what they consider full employment.

In addition, “many participants saw the U.S. economy making rapid progress toward the committee’s maximum-employment goal,” the minutes said.

“The committee has finally come around to the increasingly obvious fact that the labor market is extremely tight,” said Stephen Stanley, chief economist at Amherst Pierpont Securities.

 

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