Market Wire - Fed Minutes Foreshadow March Rate Hike, Faster Quantitative Tightening
Karl Schamotta - Chief Market Strategist
Minutes taken during the Federal Reserve’s December meeting strongly suggest that a rate hike could be on the table for March, with balance sheet reductions beginning shortly thereafter. The meeting record, released this afternoon, showed policymakers see the economy reaching “full employment” in the near future, with inflation remaining uncomfortably high for at least a year - developments that would justify increasing short-term lending rates “sooner or at a faster pace than participants had earlier anticipated”.
Officials acknowledged meeting their inflation objectives: “Participants agreed that the Committee's criteria of inflation rising to 2 percent and moderately exceeding 2 percent for some time had been more than met. All participants remarked that inflation had continued to run notably above 2 percent, reflecting supply and demand imbalances related to the pandemic and the reopening of the economy”.
Price forecasts climbed: Staff projections were raised for the near term, with “faster-than-expected increases both for a broad array of consumer prices and for wages” expected to lift the core personal consumption expenditures index slightly above target in 2022 and 2023. Meeting participants noted that measures of long-term expectations remained stable, but also worried that elevated inflation could change public psychology, making it more difficult to achieve the bank’s price stability objectives.
The central bank moved closer to achieving its employment goals: “Many participants judged that, if the current pace of improvement continued, labor markets would fast approach maximum employment”, and several said labor market conditions were “already largely consistent with maximum employment”.
But rate hikes could begin before the labour market is completely recovered: “Some participants also remarked that there could be circumstances in which it would be appropriate for the Committee to raise the target range for the federal funds rate before maximum employment had been fully achieved” - if, for example, “inflation pressures and inflation expectations were moving materially and persistently higher”.
And quantitative tightening could begin shortly afterward: Officials “noted that it could be appropriate to begin to reduce the size of the Federal Reserve's balance sheet relatively soon after beginning to raise the federal funds rate”, and “a less accommodative future stance of policy would likely be warranted” - necessitating a “strong commitment” to addressing elevated inflation pressures. Some suggested “relying more on balance sheet reduction and less on increases in the policy rate could help limit yield curve flattening during policy normalization”, while others said this might not be the case - a number of factors could influence the shape of the curve.
Runoff mechanics came up for debate: “Almost all” meeting participants agreed that the Fed’s holdings should only begin shrinking after rates began to climb, but there were varied perspectives on how the balance sheet reduction should be conducted. A number of officials argued for selling mortgage-backed securities before Treasuries, with some suggesting that the proceeds should be recycled back into Treasuries for a period of time. Some felt that a “significant amount of balance sheet shrinkage could be appropriate over the normalization process” - a clearly-hawkish signal for policy.
The dollar remained rangebound: 10-year Treasury yields climbed to levels seen last April and major equity market indices slumped, but the greenback stayed on the defensive as the reflation trade - a bet on more supportive global growth outlook and higher commodity prices - maintained its grip on currency markets. Swaps markets are now putting 80 percent odds on a rate hike at the March meeting, up from 65 percent yesterday.