January FOMC meeting preview: Fed ready to hike rates and unwind stimulus as inflation surges

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It’s a new year and new era for Federal Reserve policy — and the world is about to learn just how aggressive the U.S. central bank is willing to get with removing stimulus from a rapidly heating economy.

Consumer prices in 2021 climbed at the fastest rate in nearly 40 years, while the number of unemployed workers shrank by roughly 3.8 million in the year, reflecting the sharpest yearly drop in joblessness on record. Employers also haven’t found it easy to hire, with open positions outstripping the pool of unemployed workers. Officials are losing hope that the millions still missing from the labor market will return anytime soon as early retirements, virus fears and child care dilemmas sideline them — side effects of a labor market that’s been disrupted by a global pandemic for two years.

“The labor market is, by so many measures, hotter than it ever ran in the last expansion,” said Chair Jerome Powell at the Fed’s December meeting, when the Federal Open Market Committee (FOMC) unveiled to Fed watchers a rate-hike roadmap for the next three years that included three increases in 2022.

All of that is uniting Fed officials on “team tighten.” The question isn’t so much about when the Fed will make its first rate hike since 2018 — experts almost certainly say that’ll happen in March — but rather, how big the Fed is willing to go, and how fast it’s going to move. Experts say the Fed will likely keep interest rates steady at the end of its upcoming two-day Jan. 25-26 meeting, but will instead communicate how it plans to further dial back stimulus.

“The January meeting is an opportunity for the Fed to show how serious they are about combating inflation,” says Greg McBride, CFA, Bankrate chief financial analyst. “They could send a message that they’re serious about inflation, but that means they have to have a more aggressive posture than they did a month ago.”

Here’s four key questions facing U.S. central bankers at their first meeting of 2022 and how it could impact you.

1. How much should the Fed hike rates in March?

A growing camp of Fed officials in the weeks leading up to the Fed’s January meeting indicated that they were all on board for a rate hike in March should the economy keep evolving as they expect, including St. Louis Fed President James Bullard and San Francisco Fed President Mary Daly — a long-time dove.

Even Minneapolis Fed President Neel Kashkari, who has championed ultra-low rates to steer an inclusive labor market recovery, said he expects two hikes this year to combat inflation. Gov. Lael Brainard, who was President Joe Biden’s pick for the D.C.-based board of governor’s vice chair, called controlling inflation the U.S. central bank’s “most important task.”

“It’s inconceivable that they wouldn’t do anything in March, just given the context,” says Richard Moody, senior vice president and chief economist at Regions Financial Corporation.

Officials could raise rates by a quarter-point, the customary approach for gradually dialing back support. But considering that inflation is at 7 percent — nearly three times the Fed’s 2 percent target — experts say a half-point hike could also be on the table. That would be an aggressive move for the Fed, and the first rate hike of that magnitude since May 2000. Doing so might come as a shock to markets, though a modest share of traders are starting to brace for one, according to CME Group’s FedWatch.

“The Fed doesn’t like to shock markets, but the other side of that argument is, maybe that’s exactly what the markets need, that going 50 [basis points] could really remove any doubts anyone has about how committed they are to getting a handle on inflation,” Moody says. “That’s kind of the big question: What kind of signaling do they give on March — not in terms of timing, but magnitude.”

2. Will the Fed end its bond buying even earlier?

Another question mark is whether the Fed might decide to end its bond-buying even earlier at its January meeting, whether immediately that month or in February. Doing so would clear the runway for the central bank’s hawkish pivot.

The Fed since January has been buying $20 billion fewer Treasurys and $10 billion fewer mortgage-backed securities a month — a process known as taper that officials have already sped up once before. At the current pace, the Fed would no longer be buying assets by mid-March, timing up exactly with the Fed’s rate-setting meeting that month.

The Fed essentially increases the money supply when it buys assets. That’s because it adds those bonds onto its balance sheet, increasing banks’ reserves. The extra liquidity weighs on interest rates, especially longer-term borrowing costs that the Fed doesn’t typically control. (Think: those record-low mortgage rates that prevailed through most of 2020 and 2021.) All of that slams on the U.S. economy’s gas pedal even more, support that the financial system might not need any more as the labor market grows tighter and inflation ratchets higher. Officials haven’t raised interest rates already because they’ve still been buying bonds, policy steps that would conflict with each other.

“The Fed has to come to the realization that the economy is just running too hot for its own good,” says Sal Guatieri, senior economist and director at BMO Harris Bank. “Unless policy is tightened — and soon — we’re going to see more of the same.”

3. When will the Fed start to shrink its balance sheet and the money supply?

Halting those purchases also gives the Fed flexibility to start looking at the next step in renormalizing policy: shrinking the balance sheet by letting its bond holdings roll off.

The Fed indicated in records of its December meeting that it’s already mulling over such a step, with “some participants” on the FOMC noting it would be appropriate to begin looking at a balance sheet runoff “relatively soon” after hiking interest rates. That would provide the U.S. economy with even less momentum, coupled with more expensive borrowing that could slow growth and inflation.

“Raising rates in baby steps from near-zero levels at a time when inflation is at 7 percent is not going to solve the problem; it’s a drop in the bucket,” McBride says. “If we’re going to debate raising rates at the same time they’re carrying a $9 trillion balance sheet, it’s like having one foot on the brake and the other on the gas.”

4. How many times will the Fed hike rates in 2022?

Investors will be fixated on more than just March’s seemingly inevitable rate hike — but also the meetings that lie ahead, and how many more increases the Fed will likely be able to get on the books for the year.

“The significance of the initial rate hike, assuming it comes in March, isn’t so much about that rate hike as much as it is about the start of a series of rate hikes,” McBride says. “The Fed will likely have to boost rates at a consistent clip for two to three years to get interest rates back to what they feel is the neutral level.”

“That assumes that the economic expansion continues, and higher rates don’t bring on a sharp slowdown,” McBride adds.

Raising interest rates down the road might not be as easy as it is now. A too-aggressive Fed could worsen the job market and keep even more workers on the sidelines as it still tries to get back to its pre-pandemic levels. Supply-chain pressures and labor shortages are also currently exacerbating the current inflation picture, but expected to improve this year as the virus abates, taking some pressure off of prices even more.

The Fed could halt its balance sheet roll off and rate hikes at any time if it sees that it took too much steam away from the economy. But if it moves too slowly, it could also risk letting higher inflation get too entrenched in consumers’ expectations for the year ahead, instigating a wage-price spiral as workers start to demand higher pay.

“It all hinges on inflation — that’s now become the biggest threat to the U.S. expansion,” Moody says. “It could result in the Fed becoming more aggressive in its rate hikes. Historically, that tends not to end well for the economy.”

How higher interest rates may affect you

Consumers will want to take steps now to minimize how much they’re spending on debt, either by reducing their interest rate or eliminating their overhanging balances altogether.

If you have high-cost debt from a credit card or personal loan, consider combining that balance to reduce your interest rate and monthly payment with a balance-transfer card or personal consolidation loan. Refinancing variable-rate loans into a fixed rate could also come to your advantage.

Mortgage and refinance rates are already rising sharply, with the 30-year fixed rate already climbing back to pre-pandemic levels. If you’re still on the fence, it’ll pay to shop around and find the best deal — and quickly — before the cheapest options on the market disappear.

Investors have options for inflation-safe investments, such as Treasury Inflation Protected Securities (TIPS) or real-estate investment trusts (REITs). Avoid keeping too much of your money in fixed-income investments.

But above all, avoid knee-jerk reactions in the face of any market volatility. Facing surging inflation, the Fed doesn’t have the luxury of slowly renormalizing policy this time around, as it did after the financial crisis. Markets could be choppy in the year ahead as the Fed simultaneously trims its balance sheet and raises interest rates, something it hasn’t done before.

The prospect of extra tightening has already spooked some investors, with the Nasdaq Composite index closing Wednesday more than 10 percent below its November high, entering correction territory.

“This is uncharted territory in terms of trying to pull all this stuff off at once: Ending asset purchases, raising the fed funds rate and letting the balance sheet start to run down,” Moody says. “They don’t have a formal game plan yet, and that’s what this meeting is going to be about: reigning in that game plan and getting people comfortable with it.”

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Written by
Sarah Foster
U.S. economy reporter
Sarah Foster covers the Federal Reserve, the U.S. economy and economic policy. She previously worked for Bloomberg News, the Chicago Tribune and the Chicago Daily Herald.
Edited by
Senior wealth editor