The Federal Reserve on Wednesday said it will finish winding down crisis-driven asset purchases before its mid-March meeting, likely just in time for the first rate hike of the cycle. The 2 p.m. ET policy announcement largely tracked with Wall Street's expectations. With investors on edge for a hawkish surprise, the stock market initially extended Wednesday's already-strong gains. But the rally faltered during Fed chief Jerome Powell's press conference as short-term government bond yields jumped.
Powell stressed two things. The Fed needs to position policy to address the risk that high inflation will persist, even though that's not the base case. And the economy and household finances are strong enough to handle Fed tightening. The subtext was that a stock market drawdown, unless it's really severe, won't stop the Fed from steadily tightening policy.
In reaction, the 2-year Treasury yield has spiked to 1.2%, up about 18 basis points since before the Fed policy announcement on Thursday.
According to the CME Group FedWatch page, markets are pricing in nearly 75% odds of three quarter-point rate hikes over the next three Fed meetings through June.
In the absence of clear evidence that inflation is waning, "we think the Fed tightens at each meeting," wrote Deutsche Bank's U.S. economics team led by Matthew Luzzetti. Deutsche Bank now sees quarter-point hikes at the March, May and June meetings, with two more later in the year.
Fed Policy Statement
The Fed said that a rise in the 0%-0.25% benchmark rate "will soon be appropriate," with inflation running well above target and the labor market approaching maximum employment. That indicates the initial quarter-point rate-hike of the cycle will come at the next Fed meeting, March 15-16.
Asset purchases, which are running at a $60-billion monthly pace, will ratchet down to $30 billion in February and come to a halt in early March.
Some on Wall Street figured the Fed might halt asset purchases a month earlier, which would have signaled an even greater degree of urgency. Still, the Fed is about to execute a sharp U-turn in policy, from asset purchases to rate hikes to shrinking the balance sheet.
Powell Talks Fed Balance Sheet
The stock market began to come unglued on Jan. 5, when published minutes from the December meeting revealed a consensus that the Fed should begin reversing $4.5 trillion in Covid-era asset purchases sooner and faster than investors had anticipated.
"There's a substantial amount of shrinkage in the balance sheet to be done," Powell said in his press conference.
He said his guess is that the Fed will discuss balance-sheet policy for at least the next two meetings before announcing its plan. That would mean an annoucement about starting to gradually shrink the balance sheet as bond holdings mature could come as soon as the June 14-15 meeting.
Powell also indicated he sees the labor market as essentially having achieved maximum employment, noting "very large wage increases."
Stock Market Reaction To Fed Meeting
After the Fed meeting, the stock market initially extending healthy gains from earlier in the trading day, then reversed lower into negative territory as Powell spoke.
The Dow Jones industrial average fell 0.4%, while the S&P 500 lost 0.15%. The Nasdaq composite, which had borne the brunt of Fed fears to start the year, rose as much as 3% on the session, but turned negative as Powell spoke, before closing just above break-even.
Make sure to read IBD's daily afternoon The Big Picture column to get the latest on the prevailing stock market trend and what it means for your trading decisions.
Double-Fisted Tightening On The Way
The stock market fell into correction this month amid a realization that the Fed is way behind the curve and will resort to double-fisted tightening to try and regain control of inflation.
The Fed has its work cut out for it to shift monetary policy from being wildly accommodative to something close to neutral. That means policymakers will tighten with both fists — hiking the federal funds rate and shrinking the balance sheet. And they'll likely want to keep at it for a while, despite any modest softening of economic data. The main risk now, in most policymakers' view, is that inflation will continue to run too hot amid easy financial conditions. If that happens, the Fed would be forced to tighten even more aggressively. That's the typical recipe for a recession.
Deutsche Bank economists are expecting the Fed to start small over the summer but ramp up balance-sheet reduction to $105 billion per month by December. These economists figure that $1.5 trillion in assets would run off the balance sheet by the end of 2023, roughly equivalent to between 2.5 and 3.5 quarter-point rate hikes.
When the Federal Reserve last combined rate hikes with balance-sheet tightening, the stock market tanked in the fall of 2018, flirting with bear-market territory. Eventually, policymakers signaled retreat in early 2019, as rate hikes turned to rate cuts and the Fed renewed bond purchases.
"In dealing with balance sheet issues, we've learned that it's best to take a careful sort of methodical approach," Fed chief Jerome Powell said at his Dec. 15 news conference. "Markets can be sensitive to it."
However, it was a pretty simple matter for the Fed to backpedal in early 2019 because inflation was tame.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
