Today's Federal Reserve meeting will go down as the first rate-hike of the cycle — almost two years to the day after the Fed slashed its key policy rate to zero amid the Covid lockdown. But more importantly for the stock market, policymakers will reveal their plan to quell the biggest inflation outbreak in 40 years.
Ahead of today's Fed policy decisions, stocks were poised to continue Tuesday's rally. The major stock market indexes were sharply higher in early morning action.
While some on Wall Street think the stock market will continue to move higher once bad Federal Reserve news is out of the way. Still, it's hard to imagine that investors will like what they're probably going to hear. Federal Reserve fears and geopolitics have already driven the broad stock market into a correction and the Nasdaq into bear territory. After Tuesday's stock market rally, the Dow Jones remained 8.85% below its record closed on Jan. 4, while the S&P 500 was 11.1% below its peak. The Nasdaq composite has fallen 19.4% from its Nov. 19 record close, as rising interest rates have taken a bigger toll on growth stock valuations.
Yet pressuring the stock market continues to be part of the Fed's plan, even as some signs of rising economic fragility begin to emerge, such as the flattening Treasury yield curve.
Fed chief Jerome Powell told Congress the other week that this week's meeting is when policymakers will decide the pace at which they plan to unwind much of the $4.5 trillion in asset purchases made during the pandemic.
The Fed might reveal those details in an addendum to its policy statement, or Powell may do so in his press conference following the Fed's 2 p.m. ET policy statement on Wednesday. The Fed also will issue policymakers' quarterly economic projections, including the rate-hike outlook.
In December, the Federal Reserve penciled in three separate quarter-point rate-hikes for 2022. The new projections revealed at this week's Fed meeting will point to at least four hikes — that's the consensus — but it could be as many as six rate increases.
The Federal Reserve's Suboptimal Tool Kit
Russia's Feb. 24 invasion of Ukraine tripped a broad range of commodity price spikes amid actual and potential supply disruptions from the resource-rich region. That's only exacerbated inflation pressures already at a generational high as Covid-constrained supply struggled to catch up to stimulus-fueled demand.
Testifying to Congress on March 2, Powell explained that the Fed's tools can only address demand, not supply constraints. That's just what it plans to do, by moving away from unusually stimulative policy settings.
Surging prices can often be self-correcting, as producers ramp up supply to capitalize on high prices while consumers pare back purchases. But a series of Covid waves and now the invasion of Ukraine have made a supply response more complicated. Meanwhile, there hasn't been much demand destruction to date, thanks to strong household finances and big wage gains.
Jefferies chief financial economist Aneta Markowska says that even if oil prices were to hold near $130 a barrel, that would likely only subtract 0.5%-1% from U.S. GDP growth this year. The Federal Reserve had projected 4% growth this year, so the economy might still grow beyond its sustainable speed limit, she wrote on March 11.
"The risks to inflation are much greater" from $130 oil, Markowska wrote. The current backdrop "increases the odds that the price shock will feed through to wages, inflation expectations, and ultimately to core inflation."
Nimble Fed?
In his testimony, Powell sought to provide assurance that the Fed would be "nimble" in responding to the latest geopolitical curveball.
Powell acknowledged "the risk of potential further upward pressure on inflation expectations and inflation itself." While specifying his support for just a quarter-point rate-hike in March, Powell said the Fed could hike its key rate by a half-point at a future meeting, if inflation continues to exceed the Fed's expectations.
Deutsche Bank sees "significant risks of larger moves at the coming meetings" as price pressures broaden out to the service sector, wages accelerate and the oil-price spike jolts inflation expectations, wrote chief U.S. economist Matthew Luzzetti.
Deutsche Bank expects the Fed projections to show six quarter-point rate hikes this year.
But can the Fed be nimble in responding to downside economic risk?
Some commentators have suggested that the Ukraine conflict could make the Federal Reserve more dovish. Markowska disagrees, also citing the latest CPI data.
"Powell can't afford to take his eyes off inflation, even in the face of geopolitical risks." She expects Fed economic projections to pencil in five rate hikes for 2022 and five more for 2023.
CME Group's FedWatch page shows markets are pricing in 73% odds of at least seven rate hikes this year.
Unless the job market stalls, the Fed is likely to keep tightening.
On top of rate hikes, Deutsche Bank expects the Fed to reveal that it will start unwinding its balance sheet at a pace of up to $35 billion per month as its securities mature, rather than reinvesting principal. Asset runoff should begin by June. The cap on balance-sheet tightening could rise to $105 billion per month by October. The split would be $60 billion in Treasurys and $45 billion in government-backed mortgage securities.
QT's Stock Market Impact
If Deutsche Bank is right, the Fed could let $800 billion in assets run off its balance sheet this year. Another $1.1 trillion would follow next year. The impact of that $1.9 trillion in balance-sheet reduction might be like 3.5 rate hikes, Deutsche Bank says.
The Fed's asset purchases are widely seen as having a positive impact on stock prices. Fed buying of low-risk government securities holds down interest rates, encouraging risk-taking and underpinning stock valuations. The reverse process, dubbed quantitative tightening (QT), is therefore a headwind for the stock market. How big is, of course, hard to say.
The last time the Fed launched QT, in 2017, it went off without a hitch for the first year. But the stock market tanked in the fall of 2018, flirting with bear-market territory. Eventually, the Fed signaled retreat in early 2019, as rate hikes turned to rate cuts and QT gave way to more bond purchases.
"In dealing with balance sheet issues, we've learned that it's best to take a careful sort of methodical approach," 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 since inflation was tame. While the Fed may not want to rock the boat, it may not be able to offer a life raft.
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