Fed signals three rate hikes next year
At the conclusion of the December FOMC meeting, the Fed announced a speeding up of the taper pace, with asset purchases now expected to conclude in March rather than June, as was widely expected. With its new set of quarterly projections, the Committee also signalled a significantly steeper path of rate hikes in the coming two years than appeared in the September projections, with three rate hikes each in 2022 and 2023, and a further two hikes in 2024.
Previously, the median FOMC member projected just one hike in 2022, and three each in 2023-4. The new projections bring the FOMC into line with our own expectation for Fed rate hikes, although this is now more aggressive than the consensus expectations of two hikes in 2022, and three hikes in 2023. Accompanying this were big upgrades to inflation projections; most notable being the projection for core PCE, which is now expected to end 2022 well above target at 2.7% (September: 2.3%), and modestly above target in 2023 at 2.3% (and this is even with the more aggressive rates path). Alongside the new projections, the policy statement contained significant changes from November, including a drop of the ‘transitory’ reference to elevated inflation – something that was to be expected after Powell’s recent statement to Congress suggesting it would be ‘a good time to retire’ its use. A further big change was a complete removal of the reference to prior inflation shortfalls that was part of the Fed’s framework change last year, with this replaced with reference to inflation having “exceeded 2% for some time.” The Fed also significantly upgraded its assessment of the labour market, with reference to the unemployment rate having “declined substantially.”
Hawkish Powell emphasises inflation risks
As we had expected, Chair Powell did not hesitate at the press conference in describing the risks around inflation, stating that “there is a real risk that inflation will be more persistent,” and he reiterated a view from his Congressional testimony that high inflation “may be the chief threat to maximum employment.” Consistent with this, he said the Fed could even hike before reaching maximum employment, although when questioned, he said he still expected hikes to start after the end of asset purchases. While Powell said that the pickup in wage growth is not yet a major inflation driver, he pointed to that risk building given that the labour market is “in some ways hotter than in the last expansion.” For this reason, even a decline in goods inflation on the back of an easing in supply-side bottlenecks would not necessarily be enough to bring inflation back to target, consistent with our own view. In terms of risks, while acknowledging the risk posed by the Omicron variant, he noted that demand in the US economy was weathering successive waves of the pandemic, while emphasizing that it could further delay a recovery in labour force participation, in as much as this is being driven by pandemic-related factors.
Two further notable parts of the press conference related to financial conditions and to balance sheet runoff. On financial conditions, Powell was asked if he was concerned about hiking rates with Treasury yields still at subdued levels given the flattening effect this would have on the yield curve. He responded that he believed two factors might be explaining low Treasury yields, the first being strong global demand given very subdued rates in other developed markets, and the second being that markets might view the neutral rate as being lower. Indeed, Eurodollar futures pricing currently suggests a terminal rate of around 1.5%, i.e. 1pp lower than the FOMC’s median estimate of 2.5%. However, Powell said that bond yields by themselves were not a major concern, with the Fed paying more attention to broader financial conditions (we note here that equity market moves tend to be the main driver of US financial conditions). Second, on balance sheet runoff, Powell said that the Committee held the first of preliminary discussions, and while no decisions had been taken at this meeting, he rather cryptically noted that the environment now is very different to that under which the previous runoff was conducted, and that this difference should inform decisions around this. While it is early days, we are minded to interpret that this could suggest a more aggressive approach to balance sheet runoff than we saw in the previous cycle.