All Eyes on the Fed as the March FOMC meeting draws closer
March 7, 2022
In its recent meeting, the Fed signaled an end to its accommodative monetary policy in what could be the first hike in US interest rates since September 2018 after cutting rates by 1.5 percentage points to 0.25% at the onset of the Covid-19 pandemic in March 2020.
Even though the World Health Organization (WHO) has cautioned against assuming Omicron to be the last variant of the deadly coronavirus that emerged two years ago, a less severe Omicron and high vaccination rates have given some breathing room to policymakers around the world to address their sternest macroeconomic challenge, a stubborn rise in inflation. The US Federal Reserve is no different. In its January 26th meeting, Chief Jerome Powell hinted towards raising the interest rates as soon as March this year. “The committee is of a mind to raise the federal funds rate at the March meeting assuming that the conditions are appropriate for doing so,” Powell said. This would be the first time the Fed would raise its benchmark rate since September 2018.
Powell mentioned in his speech[1] that underlying factors such as high inflation and a decline in unemployment build a strong case for an interest rate hike and reaffirmed the Fed’s position on reducing its support to the US economy by withdrawing its asset purchases.
Taper Tantrum 2.0: A barometer for future rate hikes
Among the many things that we learned from the 2008 financial crisis, tapering is seen as the first step towards raising interest rates. When tapering was first announced in May 2013, the yield on 10‑year notes surged 57bps within the first month of the announcement and peaked ~135bps (see figure 1) to 3.01% by January 2014 when the US Federal Reserve started to scale back its $85bn/month asset purchase program. The Fed’s Quantitative Easing (QE) bond buying program officially ended in October 2014. The central bank increased interest rates by 25bps in December 2015. This was followed by nine successive rates hikes until September 2018.
Fast-forward to 2022, the markets are experiencing something of a déjà vu. On November 3, 2021, the US Federal Reserve announced that it would cut the $120bn/month in assets purchases by $15bn/month starting that November and then accelerating it to $30bn/month by January with a complete withdrawal by March-end. Since then, the US 10-year benchmark yield has climbed ~23% to 1.986% until the end of February 2022. Meanwhile, the broader benchmark index S&P 500 has fallen 6% (see figure 1). This time around, the Fed policy action has been swift due to hardening inflation, with an accelerated scale-back and complete withdrawal by March 2022 (within 6 months of the original announcement), followed by a strong expectation of a first rate hike in March and then Quantitative tightening expected by mid-2022.
Figure 1: Market volatility has historically been triggered by taper talks
Description: The S&P 500 index has fallen by ~6% since November 2021 when the US Fed announced that it was curtailing its monthly asset purchases, while the 10yr yield has risen 23% during this period in a stark reminder to the 2008 financial crisis when a similar pattern was observed following the tapering announcement in May 2013. Source: S&P 500, New York Fed and US Treasury Department
Tapering the QE: Post-financial crisis vs. Covid-19 pandemic
The Federal Reserve launched a QE program in three tranches between 2008 and 2012 that saw purchases of $85bn a month in Treasury bonds, MBS and agency debt, which expanded the Fed balance sheet from a pre-crisis level of ~$0.8tn to ~$4.2tn by the end of 2014 (see figure 2). Buoyed by strong economic data, with unemployment falling to the then five-year low of 6.9% and inflation rising to 1.6% (closer to the 2.0% target), the Fed began to curtail its asset purchase program by $10bn a month starting in January 2014.
QE during the pandemic increased to $120bn a month ($80bn in Treasury bonds and $40bn in residential and commercial mortgage-backed securities) starting in June 2020, leading the Fed’s balance sheet to more than double to ~$8.9tn from its pre-pandemic level (see figure 2). These monthly purchases would have resulted in ~$2tn in balance sheet expansion in the following 21 months. In November 2021, the Federal Reserve announced that it would cut its asset purchases by $15bn/month, accelerating it to $30bn/month by January after seeing a sharp rise in core inflation (PCE), which had increased to 5.2% by January 2022, a rate much higher than its 2.0% target, thus necessitating a need for a rate hike. Although a highly accommodative policy coupled with large-scale stimulus packages[2] spiraled the inflation to a 40-year high, it helped bring down the unemployment rate from 14.7% in April 2020 (the highest level since the Great Depression) to 4.0% by January 2022.
Figure 2: Fed balance sheet has more than doubled from its pre-pandemic level
Description: The Fed balance sheet has more than doubled to $8.9tn from its pre-pandemic level high due to the $120bn/month in asset purchases, an amount higher than $85bn monthly bond buying program that concluded in October 2014. Source: Fred.stlouisfed.org
Despite rising geopolitical tension, markets bet on a “hawkish policy stance[3]” with the Fed running behind the inflation curve
A higher asset reserve implies excessive liquidity, meaning higher inflation, which is cause of concern for policymakers. Unwinding the Fed’s balance sheet would be a positive step towards taming the core inflation, which has reached a 40-year high of 5.2% in January 2022. This would also help the Fed in going back to using interest rates as its primary monetary policy instrument, as any type of QE is primarily seen as an emergency step towards inducing demand.
Strong economic data, such as a fall in the unemployment rate to 4.0% and 5.7% real GDP growth[4] in 2021, the largest since 1984 (albeit on easy comps considering 2020 GDP growth was -3.4%), has enabled the Fed to tighten its monetary policy. However, the debate has shifted to how many times the Fed can raise interest rates this year to bring the core inflation down to its long-term target of 2.0%.
Until recently, the odds for a 50bps hike in February were as high as 92.8%, but Fed Chair Powell in a testimony on March 2, appeared more inclined towards raising the interest rates by 25bps[5]. “I’m inclined to propose and support a 25bps rate hike,” Powell said. “The bottom line is that we will proceed, but we will proceed carefully as we learn more about the implications of the Ukraine war for the economy,” he added. Markets are now betting on a 92.0% probability of a 25bps hike in March, with Fed rates likely to increase to 1.50% by end of this year (see figure 3). This could be the fastest pace of hikes since the June 2004 to July 2006 period, when the rates had increased by a cumulative 4.25 percentage points. Spiraling geopolitical tension could have a bearing on the Fed rate hikes in the immediate future.
Figure 3: Rate hike probability meter
Description: Markets are betting on a 92.8% probability of a 50bps hike in interest rates at the March 2022 meeting, followed by a 64.7% chance of a 25bps increase in subsequent meetings in May, June, September and November. Interest rates would eventually increase to 1.75-2.00% range by the end of this year. Source: CME’s Fed Watch
The most recent CNBC Fed Survey also points to an extremely hawkish Fed, with the number of rate hikes rising to 3.7 this year, followed by three hikes in 2023 (see figure 4). This would lead the target rates to increase to just over 1.0% by the end of this year from the current 0.25% level, before rising to 1.8% by year-end 2023 and 2.4% by March 2024.
Figure 4: CNBC Survey respondents expect a “Hawkish Fed”
Description: CNBC Fed Survey respondents expect 3.7 rate hikes this year followed by 3 hikes in 2023, with Federal Fund rates rising to just over 1.0% by the end of this year before rising to 1.8% in end-2023 and 2.4% by March 2024. Source: CNBC Fed Survey
Quantitative Tightening 2.0 comes with safety nets
Once the QE program ends by March 2022 and the rates begin to rise again, the Fed would have to embark on the next challenge of unwinding its gigantic balance sheet that has swelled to an all-time high of nearly $9tn. It remains unclear by how much and by how far the Fed would reduce its balance sheet, but analysts expect the QT to begin in July, with reductions reaching $100bn/month by year-end[6] and asset reserves to fall to pre-pandemic levels by 2026. The pace of reductions would be much faster than during 2017-19, which saw about $650bn of bonds being rolled off the Fed’s portfolio i.e., the balance sheet shrinking by just ~15% during that period. Even this time, the Federal Reserve has expressed reducing its holdings by letting billions of dollars of securities mature each month without reinvesting them; however, it did not rule out the possibility of pursuing a more aggressive tactic, which would be actively selling some of its assets. “If the situation turns out to be different than we had thought, we’re not going to stick with something that isn’t working,” stated Fed Chair Jerome Powell.
One of the consequences of QT that we anticipate is an increase in short-term interest rates. The Fed’s effort to reduce its asset portfolio during the first QT led to a low level of reserves that the bank maintains, which led to a spike in overnight financing rates in September 2019 (see figure 5). The Fed was forced to intervene by injecting billions of dollars in the repo market.
However, this time, we see the Fed’s Standing Repo Facility[7] (SRF) that came into effect last year as serving as a backstop for banks in need of immediate cash. Financial firms and entities could instead borrow directly from this facility if they are running low on reserves, thus averting another surge in overnight financing rates.
Figure 5: Short-term interest rates surged during QT1 as the Fed’s asset holdings declined
Description: A drop in the Fed’s asset reserves led to a surge in short-term borrowing costs during QT1, forcing the Fed to pump billions of dollars in repo markets. A similar spike in overnight repo rates could come around this time as well; however, the Fed’s SRF tool could offset some of its impact, allowing banks to borrow directly from this facility. Source: New York Fed
Higher rates may discourage additional borrowings
It is usually prudent for the government to borrow under a low-rate environment, which in turn adds to the national debt. In January 2022, US government debt surpassed the $30 trillion mark for the first time in history (see Figure 6) as the Treasury was forced to raise auction sizes across all maturities during the financial crisis in 2008-09 and in response to the Covid-19 pandemic. Any potential future rate hikes would discourage raising additional debt by making the process more costly, thus keeping the national debt in check. The debt ceiling was already raised by $2.5tn to $31.4tn[8] in December last year, and even this year, this limit will likely be breached, despite the reductions in Treasury coupon auction sizes.
Figure 6: Total public debt reaches record high amid increased government borrowing
*Treasury Notes and Bonds with maturities ranging from 2 years to 30 years only have been shown as total coupon supply.
Description: The US public debt has crossed the $30tn mark for the first time in history fueled by increased government borrowings following the 2007-08 financial crisis and fiscal response to Covid-19 pandemic. Source: US Treasury Department and FiscalData.Treasury.gov
Conclusion: Hawkish monetary policy and fiscal stimulus
The Federal fund rates is likely to be raised in March this year after staying at a 0.25% level for nearly two years. The underlying data necessitate a hike in benchmark rates as inflation has risen to 5.2% during this period, higher than the Fed’s 2.0% long-term target and the highest levels since 1980s. Though unemployment data are supportive of the US economy remaining overheated. Until recently, the markets were in favor of a 50bps hike; however, in the March congressional testimony, Fed Chair Powell appeared to be in favor of a 25bps rate hike, constrained by the worsening of the geopolitical risk and its potential spillover effect on the US economy. Even before the Russia-Ukraine crisis flared up, the economists had lowered their 2022 GDP growth forecast to 3.2%[9] from an earlier estimate of 3.8%. In case of a slowing economy (or stagflation), we believe the increase in rates might not be as frequent as predicted until few weeks back. The street is currently assigning a 92.0% probability of a 25bps rate hike in March, with Fed rates likely to increase to 1.50% by end of this year.
Moreover, the Fed is likely to go ahead with its planned winding down of the balance sheet, which has expanded to a record ~$9tn levels. Once QE ends in March, the Fed would aim to reduce its asset portfolio by rolling billions of dollars in securities off its balance sheet as they mature, or they may sell some of their assets directly, thus pursuing a more aggressive approach if needed. Analysts expect the Fed to shrink its holdings starting in July 2022, with monthly reductions rising to as high as $100bn by year-end and reserves could fall to pre-pandemic levels by 2026, with annual QT running as high as $1tn annually starting 2023. However, we reckon the ongoing Russia-Ukraine conflict has heightened uncertainties and there is a possibility that the Fed may buy more time (to fully assess its implications on the US economy) before undertaking a decisive policy action with regard to the timing and magnitude of the quantitative tightening.
Among other aspects, the overnight financing rates generally harden as a direct fallout of balance sheet reduction as seen previously (2017-19). Though, this time around, some of the impact could be mitigated with the introduction of the SRF tool by the Fed in 2021, as it would allow financial firms to borrow directly from the facility.
The US national debt has shot past the $30tn mark for the first time in history as the country borrowed billions of dollars through Treasury auctions to fund its Covid-19 relief programs. Higher interest rates would discourage additional borrowings by making the cost of raising debt more expensive; however, we still see potent risk of the US breaching its debt limit later in this fiscal year. As a reminder, the US debt ceiling was raised to $31.4tn last year after lawmakers in a fierce battle approved raising the statutory limit by $2.5tn, narrowly avoiding a government default. Back in 2011, the S&P downgraded the US long-term credit rating to AA+ after the debt ceiling was raised by $2.4tn following massive government spending in response to the 2007-08 financial crisis. The threat of a rating downgrade looms even this year as the Biden administration is not looking to make cutbacks to its $1.7tn Build Back Better[10] plan, adding to an already mounting national debt crisis.
[1] Transcript of Chair Powell’s Press Conference January 26, 2022 (US Federal Reserve)
[2] Please read our blog Generosity has its price: Decoding Biden’s infrastructure push (published in April 2021) to find out more on stimulus packages approved under the Trump and Biden administrations.
[3] Investors gird for more hawkish Fed after sharp inflation rise (Reuters)
[4] U.S. Economy Grew At The Fastest Rate Since 1984 Last Year (Forbes)
[5] Powell backs quarter-point rate rise in March despite Ukraine war effects (Financial Times)
[6] Fed Balance Sheet May Shrink By $100 Billion A Month, Adding To Stock Market Risk (Investor’s Business Daily)
[7] The Fed’s Latest Tool: A Standing Repo Facility (New York Fed)
[8] Congress votes to lift US debt ceiling to narrowly avoid default (Financial Times)
[9] Goldman Sachs has cut its US 2022 GDP forecast again and warned of a sharp slowdown in growth (Markets Insider)
[10] The Build Back Better Framework (The White House)
