The Federal Reserve and the Great Unwind of 2022.

Quick Summary:

·      First rate hike of 25 basis points (0.25%) slated for March

·      More rate hikes to come in 2022, but timing will be data-driven

·      Further reduction in bond-buying

·      Fed to begin shrinking the balance sheet as early as summer

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Yesterday, Federal Reserve Chair, Jerome Powell, delivered one of the most anticipated press conferences on the economic calendar in years.

In his speech, Powell laid the path to unwinding the most extraordinary monetary stimulus measures in US history. This will likely begin with an interest rate rise in March. The path to unwinding was always going to be paved with full employment, hot inflation and a broadly recovered economy. All of these conditions are now present – and the Fed has committed to that direction accordingly.

Many were worried (while others were hoping) that the Fed would move aggressively to reign in it’s covid-era stimulus measures in an effort to contain inflation; by calling an instant end to bond-buying, raising interest rates and announcing a decisive move to reduce it’s bloated, $9 trillion balance sheet. That didn’t quite happen.

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Controlling Inflation

Inflation has probably had more airtime in the past few months than it has since 1981. As we’ve discussed previously, this has largely been driven by a tsunami of US savings being unleashed against broken supply chains, which were simply too fragile to absorb all the pent-up demand. Further to this, we said inflation was likely to moderate throughout the first half of 2022. We’re sticking with that view for now, unless something else crazy happens, or a great reason to abandon it comes through in the data.

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Rising Interest Rates

The Fed will likely raise interest rates by 25 basis points (0.25%) at their meeting in March (the committee doesn’t meet in February). This was widely expected by markets. The path to further rate hikes throughout the year is less certain though, as is the outlook for inflation and economic growth.

We expect probably three rate hikes this year. At this stage there appears to be a limited basis for four hikes, but some traders are pricing in as many as five. It wouldn’t be a surprise to see real interest rates (interest rate – rate of inflation = real interest rate) still negative at the end of 2022.

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Shrinking the Balance Sheet

Heard about all that money printing over at the Fed? Well, buying bonds and other assets is what the Fed does with all that ‘printed’ money. These assets have included everything from corporate junk bonds to mortgage backed securities (MBS). The expansion of the Fed’s balance sheet since the beginning of the pandemic has now run from less than $1 trillion in 2007 to around $9 trillion today (see chart below). Shrinking the balance sheet means gradually selling some of the assets it has purchased. The prospect of this has been very, very bad for the most extreme risk assets, like cryptos and super-expensive stocks, because it represents an end to the days of the financial system being awash with easy money; the staple upon which the riskiest assets feed.

Instead of announcing an immediate end to bond buying as some had hoped, they’re going with an accelerated taper (still buying, but at a slower pace). Actually shrinking the balance sheet likely won’t start until summer at the earliest. Let’s see how that shapes up.

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Outlook

Our working assumption that inflation would moderate quickly in 2022 seems, for now, to remains intact. Despite the noise around this topic, all indicators show that the whopping 7% inflation reading from December is unlikely to be repeated. One material risk here is a major conflict (eg. with Russia or China), or a new and dangerous covid variant, which may have potent inflationary consequences.

Personally, I think the Fed is being reasonable. Many commentators will no doubt disagree with that assessment, but something will crack in the global financial system if the Fed spends it’s time jumping at shadows. We need them to move slowly. Inflation will ease. Growth will moderate. Supply chains will recover. Let’s not overstep.

The conditions to justify a gradual tightening of monetary conditions in the US are well and truly in place – and I will admit that the current stance is perhaps a bit overdue. The conditions to justify a very aggressive tightening do not seem to be there though, at least in my humble opinion.

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