Fed’s ‘pivot is complete’ in the face of inflationary pressures

Roughly two weeks before the Federal Reserve wrapped up December’s meeting on monetary policy, Jay Powell sent a clear message to US lawmakers and market participants that change was afoot.

“You’ve seen our policy adapt, and you’ll see it continue to adapt,” the Fed chair told members of the Senate banking committee on the final day of November.

On Wednesday the scope and scale of that adaptation was crystallised, with the US central bank announcing that it would more speedily withdraw its pandemic-era stimulus programme. At a time of surging inflation and a recovering labour market, the move would give the Fed more flexibility to raise US interest rates early next year.

“The pivot is complete in terms of them worrying about more persistent and problematic inflation,’‘ said Diane Swonk, chief economist at Grant Thornton. “It is a late realisation but they are there, which is important.”

With the stimulus consisting of monthly government bond purchases now set to end in March, Fed officials now expect to raise rates three times in 2022.

That is a significantly more aggressive pace than just a few months ago when policymakers were evenly split on the notion of a 2022 lift-off from today’s near-zero rates. Members of the Federal Open Market Committee and other regional Fed presidents signalled their support for three more rate rises in 2023, and another two moves in 2024.

The Fed’s less patient approach and its shift away from the ultra-loose monetary policy, despite a worrying wave of new coronavirus cases linked to the Omicron variant, underscores the immense pressure piling up on the central bank to do more to tame inflation.

Powell justified the hawkish pivot by highlighting the underlying strength of the US economy, which Fed officials expect to expand by 5.5 per cent this year and 4 per cent next year, and the spread of inflationary pressures through a broader cross-section of the economy. Speaking at a press conference, he also stressed the importance of keeping prices stable to support steady and more inclusive growth.

He acknowledged that the current inflation level is “not at all” what the Fed was looking for when it rolled out a new policy framework in August last year, which indicated a higher tolerance for swifter consumer price growth. With core inflation currently running at 4.1 per cent and only set to moderate to 2.7 per cent next year, according to the median Fed forecast, the central bank declared its inflation test for lifting interest rates met.

While Powell noted that progress towards maximum employment has been “rapid” — so much so that there need not be a “long delay” between the end of the bond purchase programme and the first interest rate increase — the hawkish turn seemed to suggest a “changing in the hierarchy” in the Fed’s dual priorities of full employment and stable prices, said Seth Carpenter, who spent 15 years at the central bank.

“The way they had been formulating their approach to policy before Covid was in a world where you had a very, very long expansion, extraordinarily low unemployment, still very muted inflationary pressures and the recent history of inflation being too low relative to the target,” said Carpenter, who is now the global chief economist at Morgan Stanley. “Because the world has changed pretty substantially, their approach is changing in response to it.”

The Fed has previously said it would keep interest rates tethered close to zero until it achieved inflation that averages 2 per cent for some time and maximum employment.

Powell on Wednesday suggested the jobs market in future may look different than the one before the Covid shock, especially in terms of participation in the workforce, suggesting the Fed may be willing to raise rates before full suite of labour statistics resemble those last seen in February 2020.

“They definitely have lowered their expectations about what they are getting in the near-term,” said Julia Coronado, a former Fed economist now at MacroPolicy Perspectives. “Their ultimate objective now is a stable expansion, and to get that they feel they need to cool off inflationary pressures. And that means removing more accommodation earlier than they previously expected.”

Financial markets took the Fed’s more assertive posture in their stride, with the S&P 500 stock index advancing 1.6 per cent and the technology-heavy Nasdaq Composite notching a gain of 2.2 per cent.

Jean Boivin, who now heads up the BlackRock Investment Institute after serving as deputy governor at the Bank of Canada, attributed the positive reaction in part to the more “muted hiking cycle” suggested by the so-called dot plot of individual interest rate projections.

A majority of Fed officials expect the policy rate to reach only 2.1 per cent in 2024, well shy of the 2.5 per cent longer-run target. Expectations implied in futures markets are even more subdued, suggesting a 1.5 per cent level around that time.

“Their dots are suggesting a faster pace but they end up at the same place,” Boivin said. “It doesn’t send the message that we really need to slam the brakes here.” 

Swonk warned that financial markets could be at risk of a sharp sell-off, however, if the Fed does indeed tighten policy much more substantially to root out entrenched inflation.

“Many rate hiking cycles have had the Fed off to the races and then they have to pull back,” she said. “Markets seem to be expecting that scenario to play out again and are not acknowledging that this time really could be different.”

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