On January 26, the Federal Reserve has released the statement of its first monetary policy meeting in 2022. The Federal Open Market Committee (FOMC) left the federal funds rate unchanged at 0-0.25%, continuing the current pace of tapering. This implies that the Fed will end asset purchases and raise interest rates in March, as well as shrink the size of its balance sheet. This result was actually in line with the expectations of most market institutions. However, Fed Chair Jerome Powell also caused concern by revealing some information that it will accelerate the pace of tapering.
Powell's confirmation of his plan to end bond purchases and raise interest rates in March essentially clarifies when the Fed will start raising rates. He noted that the Fed "has quite a bit of room to raise interest rates without threatening the labor market and does not rule out raising rates at every FOMC meeting". Powell also revealed that the Fed "would reduce balance sheet sooner and faster than last time". This implies a faster pace of rate hikes, almost double the 3-4 rate hikes expected late last year if they occur at every meeting after tapering is completed, and will likely return rates to near pre-pandemic levels by the end of the year. Adding to market pressure was Powell's talk of shrinking the size of the Fed's balance sheet, which he said would begin after interest rate increases. He said the meeting has set guidelines for the tapering decision, but the central bank has yet to decide internally on the timing and pace of reducing the balance sheet, and will hold at least one meeting after the first rate hike to make a decision on the balance sheet reduction. "I expect that we will discuss that at our upcoming meeting". This signifies the balance sheet reduction is likely to start much earlier than previously expected at the end of the year.
Economic development, of course, still largely depends on the course of the novel coronavirus. Progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation. Risks to the economic outlook remain, including from new variants of the virus. For financial markets, on the one hand, the Fed will not adopt a yield curve control approach. Powell said the Fed monitors the slope of the yield curve but does not control it. On the other hand, the Fed stressed that tighter monetary policy would not pose a threat to capital markets. The Fed chair said while asset prices were somewhat high, he did not see them as a significant threat to financial stability and mentioned that the fragility of financial stability was manageable. These statements indicate that the Fed is likely to withstand the negative pressure on capital markets from monetary tightening and focus on addressing inflation.
The reason the Fed is in such a hurry to tighten policy, as ANBOUND noted earlier, is that rising inflation has become the main contradiction facing the U.S. economy. Powell stressed that "inflation remains well above the target and long-term economic expansion requires price stability". He also emphasized that there has been significant progress in the labor market and that the improvement is broad-based. The labor-force participation rate rose slightly, but remains depressed. "Wages are growing at the fastest pace in years and we are concerned about the risk that wage growth will affect prices". It is in fact, the high level of inflation in the U.S. that has prompted the Fed to abandon its view that inflation is "transitory" and take a "sharp turn" in its policy. In the case of U.S. inflation, as the Fed notes, the U.S. economy has recovered faster for most of 2021, supporting the improvement in employment but bringing a higher level of inflation.
Powell, who is confident that monetary policy will curb inflation, said there are multiple factors that could bring inflation down this year and that he is prepared to use policy tools to ensure high inflation is kept under control. "Our objective is to get inflation back down to 2%. The fiscal boost to growth will be much less, which will also help keep inflation in check". Regarding the impact of supply chain distortions on inflation, Powell said, "inflation has eased slightly since last December's meeting. We do expect supply chain issues to subside this year, but more slowly than expected. The situation in Eastern Europe is also a risk". He also said that the semiconductor issue will continue beyond 2023, the current supply chain issues have not made significant progress, and he expects progress in the second half of the year.
Judging from the information revealed at the meeting, ANBOUND believes there are still several concerns. The first is whether the Fed's tightening policy will have a negative impact on the U.S. economy. Despite the Fed's view that the U.S. economy is still in high gear, the current PMI and labor market situation suggest that the U.S. economy is beginning to show weakness in the face of the new wave of the pandemic. The IMF and the World Bank, among others, have lowered their forecasts for U.S. economic growth. Continued tightening of monetary policy will have a negative impact on the U.S. economy, which has not fully recovered, further slowing the trend of economic growth. This, of course, is good for tackling inflation. In this case, the Fed still faces a dilemma.
The second concern is whether the Fed's policy can play a role in curbing inflation. The inflation problem is not entirely the result of a short-term demand rebound, but of distortions in labor markets and in global supply chains. The Fed also saw continued strength in U.S. economic activity and employment indicators. Supply and demand imbalances related to the pandemic and the reopening of the economy continue to lead to higher levels of inflation. Thus, the inflation problem is not entirely caused by a rebound in demand. In addition, the supply-side problem is clearly not something that monetary policy can solve by itself. Some market analysts said the Fed was simply buying time and waiting for supply chains to recover. Inflation will then drift lower, and the Fed can take credit for that. In this light, the Fed's aggressive policy may prove superfluous.
The third concern is the extent to which the Fed can withstand the resulting volatility in capital markets. In the case of changing market expectations, the U.S. capital markets have faced a climb in bond yields and a pullback in equity markets since 2022. The 10-year Treasury yield is once again nearing the 1.9% level, and both the Nasdaq and the S&P 500 are in correction territory. If the capital market continues to fall, it will also have an indirect impact on household wealth and the real estate market. Judging from historical experience, all previous rate hikes by the Fed have brought about various forms of the financial crisis, and the unprecedented policy "sharp turn" may be even more unbearable for global capital markets, including the United States. At that time, there is still a lot of uncertainty whether the Fed will be able to withstand pressures from the Wall Street and the U.S. government, that it would stick to its policy stance.
The Fed's acceleration of the pace of tapering has further exacerbated the policy risks mentioned by ANBOUND's researchers. Many market participants have criticized the Fed's monetary policy as "out of step". Some of them see the Fed as a very slow-moving ship, with its monetary policy designed to lag by 9-18 months. Such approach is not only difficult in affecting the trend of inflation, but will also bring about more problems to the economy.
Final analysis conclusion:
The Fed's new policy decision signals a further acceleration of monetary tightening. However, whether such a "sharp turn" can curb inflation and boost the economic growth remains a worrying issue.
