Smart Talk Success

Facing both turbulent financial markets and raging inflation, the Federal Reserve on Wednesday indicated it could soon raise interest rates for the first time in more than three years as part of a broader tightening of historically easy monetary policy.

In a move that came as little surprise, the Fed’s policymaking group said a quarter-percentage point increase to its benchmark short-term borrowing rate is likely forthcoming. It would be the first rise since December 2018.

Chairman Jerome Powell added that the Fed could move on an aggressive path.

“I think there’s quite a bit of room to raise interest rates without threatening the labor market,” Powell said at his post-meeting news conference. After being up strongly earlier, the major stock market averages turned negative shortly following Powell’s pronouncement.

The committee’s statement came in response to inflation running at its hottest level in nearly 40 years. Though the move toward less accommodative policy has been well telegraphed over the past several weeks, markets in recent days have been remarkably choppy as investors worried that the Fed might tighten policy even more than expected.

The post-meeting statement from the Federal Open Market Committee did not provide a specific time for when the increase will come, though indications are that it could happen as soon as the March meeting. The statement was adopted without dissent.

“With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate,” the statement said. The Fed does not meet in February.

In addition, the committee noted the central bank’s monthly bond-buying will proceed at just $30 billion in February, indicating that program is expected to end in March as well at the same time that rates increase.

There were no specific indications Wednesday when the Fed might start to reduce bond holdings that have bloated its balance sheet to nearly $9 trillion.

However, the committee released a statement outlining “principles for reducing the size of the balance sheet.” The statement is prefaced with the notion that the Fed is preparing for “significantly reducing” the level of asset holdings.

That policy sheet noted that the benchmark funds rate is the “primary means of adjusting the stance of monetary policy.” The committee further noted that the balance sheet reduction would happen after rate hikes start and would be “in a predictable manner” by adjusting how much of the bank’s proceeds from its bond holdings would be reinvested and how much would be allowed to roll off.

“The Fed’s announcement that it will ‘soon be appropriate’ to raise interest rates is a clear sign that a March rate hike is coming,” noted Michael Pearce, senior U.S. economist at Capital Economics. “The Fed’s plans to begin running down its balance sheet once rates begin to rise suggests an announcement on that could also come as soon as the next meeting, which would be slightly more hawkish than we expected.”

Markets had been anxiously awaiting the Fed’s decision.

Investors had been expecting the Fed to tee up the first of multiple rate hikes, and in fact are pricing in a more aggressive schedule this year than FOMC officials indicated in their December outlook. At that time, the committee penciled in three 25 basis point moves this year, while the market is pricing in four hikes, according to the CME’s FedWatch tool that computes the probabilities through the fed funds futures market.

Traders are anticipating a funds rate by the end of the year of about 1%, from the near-zero range where it’s currently pegged.

Fed officials have been expressing concern lately about persistent inflation, following months of insisting that the price increases were “transitory.” Consumer prices are up 7% from a year ago, the fastest 12-month pace since the summer of 1982.

The durability of inflation has caused officials to rethink a strategy that has produced the easiest monetary policy in Fed history. The central bank slashed its benchmark rate to a target of 0%-0.25% in the early days of the Covid pandemic and has been buying billions of dollars in Treasurys and mortgage-backed securities each month.

“Part of this will be the Fed moving away from very high accommodative policy to substantially less accommodative policy and over time to a policy that’s not accommodative,” Powell said.

The bond-buying program, sometimes called quantitative easing, has brought the Fed’s total assets on its balance sheet to nearly $9 trillion. Powell said the Fed will wait a few months then probably start allowing some of the proceeds from its bond holdings to run off each month while reinvesting the rest. As things stand now, the Fed reinvests all of those proceeds.

“The balance sheet is substantially larger than it needs to be,” Powell said. “There’s a substantial amount of shrinkage in the balance sheet to be done. That’s going to take some time. We want that process to be orderly and predictable.”

Goldman Sachs said a few days ago that it expects the balance sheet reduction to start in June at a pace of $100 billion a month, about double the pace of the previous move of a runoff several years ago.

This is a comparison of Wednesday’s Federal Open Market Committee statement with the one issued after the Fed’s previous policymaking meeting on Dec. 15.

Text removed from the December statement is in red with a horizontal line through the middle.

Text appearing for the first time in the new statement is in red and underlined.

Black text appears in both statements.

The CNBC Fed Survey shows market expectations have turned aggressive for Federal Reserve policy tightening this year and next, with respondents looking for multiple rate hikes and significant balance sheet reduction.

The first hike is now firmly seen coming in March, compared with a June expectation in the December survey. Respondents expect 3.5 rate hikes this year, showing that three are agreed but there is debate over whether there’s a fourth. Half of the 36 respondents see two or three hikes this year, and half see four or five.

An additional three hikes are expected next year. That makes the forecast for a funds rate of just over 1% this year, compared to around zero now, 1.8% in 2023 and a terminal rate, or the end-point of the hiking cycle, at 2.4% reached in March 2024.

“The Fed has pivoted from patient to panicked on inflation in record time,” Diane Swonk, chief economist at Grant Thornton, wrote in response to the survey. “That ups the risk of a misstep in policy, especially in light of the complexity of inflation dynamics today.”

The central bank’s two-day meeting ends Wednesday, where it is expected to give more clues as to when it will hike rates and begin shrinking the balance sheet. Chairman Jerome Powell will also address the media.

The balance sheet runoff is seen beginning in July, much earlier than the last survey, which pegged the beginning in November. While the Fed has yet to formulate a plan for balance sheet runoff, here is a first look at how respondents believe it could happen: 

• $380 billion to come off the $9 trillion balance sheet this year and $860 billion in 2023.
• Monthly runoff pace of $73 billion eventually, far faster than the last runoff in 2018, but the Fed will phase in this monthly pace.
• $2.8 trillion in total runoff or about a third of the balance sheet over 3 years.

Most support the Fed reducing the mortgage portfolio before Treasurys, letting short-term Treasurys runoff before long-term ones and only reducing the balance sheet by not replacing securities that mature, rather than outright asset sales.

“Investors are under-appreciating risk in the financial system,” said Chad Morganlander, portfolio manager at Stifel Nicolaus. “The wave of liquidity and the zero-interest policy have distorted all markets. The Federal Reserve should have shifted policy a year ago.”

91% of respondents say the Fed is significantly or somewhat late in addressing inflation.

“The Fed should start by raising rates aggressively, that is, 50 bps initially, so it can throttle back later when/if supply chain issues start resolving themselves and inflation comes down as a result,” wrote Joel L. Naroff, president, Naroff Economics LLC, in response to the survey.

Respondents marked down their outlook for stocks but only modestly compared to how much they boosted their outlook for Fed rate hikes. The S&P 500 is seen ending the year at 4,658, or a 5.6% increase from the Monday close. That’s down from the December forecast of 4752. The S&P is forecast to rise to 4889 in 2023.

The CNBC Risk-Reward ratio, which gauges the probability of a 10% increase or decline in stocks over the next six months, fell to -14 from -11 in the last survey. There is an average 52% probability of a 10% decline in the next six months, compared to just a 38% probability of a 10% gain.

With an increase in the outlook for Fed tightening and the recent Omicron wave, respondents’ economic forecasts have come down. The forecast for GDP fell to 3.5% for this year, down from 3.9% in the December outlook, and 2.7% for 2023, down from 2.9%. The average CPI forecast was raised by about 0.4 percentage points this year to 4.4% and to 3.2% next year.

The unemployment rate is expected to fall to 3.6% this year, compared to the current rate of 3.9%. The chance of recession in the next year rose to 23% from 19% but remains about average. Inflation is seen as the No 1. threat to the expansion and 51% believe the Fed will have to raise rates above neutral to slow the economy.

“Assuming the pandemic continues to recede – each new wave of the virus is less disruptive than the previous one – the economy will be at full employment and inflation near the Fed’s target by this time next year,” wrote Mark Zandi, chief economist, Moody’s Analytics.

(Due to an error in a response to the survey, an earlier version of this story reported that respondents’ GDP forecasts rose for 2022 and 2023. They actually declined to 3.5% from 3.9% in the December survey for 2023 and to 2.7% from 2.9% for 2023.)