Fed’s Message: Get Ready

The Federal Open Market Committee (FOMC) of the Federal Reserve did not make any formal changes to its policy, but did signal it would begin raising the fed funds rate soon. “With inflation well above 2% and a strong labor market, the committee expects it will soon be appropriate to raise the target range for the federal funds rate.” In a separate statement, the FOMC noted it expects the balance sheet reduction process (aka, quantitative tightening, or QT) “will commence after the process of increasing the target range for the federal funds rate has begun.” At present, the Fed’s balance sheet is nearly $9 trillion; more than twice its size at the start of the pandemic.

The stepped-up pace of normalizing monetary policy reflects ongoing inflation pressures, including a 7% consumer price index (CPI) rate and the faster retreat in the unemployment rate since the pandemic erupted. In keeping with the latter, the statement eliminated this section of the December statement: “…appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment.”

The announcement said the Fed will conclude asset purchases on schedule in “early March.” The Committee agreed to a basic set of principles for balance sheet reduction, while emphasizing that the fed funds rate remains the Fed’s main policy tool and that it does intend to continue to hold Treasury securities longer-term. Kathy Jones, Schwab’s Chief Fixed Income Strategist, noted that the decision to hold Treasuries “reflects some discomfort on the part of some Fed members that the Fed has gone very far away from its traditional stance in these various quantitative easing programs.” In addition, there may be “discomfort with the idea that by supporting the mortgage market, they may be contributing to the rise in housing prices, which contributes to inflation through the rise in rent.”

The statement did not specify anything concrete with regard to the pace of rate hikes (four of which are priced in by the market this year), but Fed Chair Jerome Powell remarked that “the committee is of a mind to raise the fed funds rate at the March meeting,” which is in keeping with the consensus (and our view). But market watchers should continue to heed the message from the Fed that their ongoing decisions with regard to the pace and frequency of rate hikes will be data dependent; with Fed Chair Jerome Powell continuing to believe that inflation will decline over the course of this year.

The yield on the 10-year Treasury edged up after the announcement and the yield curve steepened a bit. The initial reaction by stocks was to add to the day’s gains; but that soon gave way for another bout of selling as of this writing. Of course that comes in the midst of what has been an extraordinarily volatile year, in large part courtesy of the move toward tighter monetary policy.