December Fed meeting preview: Will soaring inflation force officials to withdraw stimulus faster?

Photo by Getty Images; Illustration by Bankrate

The Federal Reserve spent months carefully crafting a plan to walk back its extraordinary stimulus — and just four weeks after putting it into action, U.S. central bankers are already ready to pivot, illustrating how worried they are about the economy overheating as inflation skyrockets by the fastest pace in almost 40 years.

The Fed in November announced that it would start slowly trimming how many bonds it’s buying by a pace of $15 billion a month, a policy known as “taper.” The pace was minuscule compared to the $120 billion a month the Fed had been purchasing since June 2020, but it was the first official step toward renormalizing policy, illustrating just how far the recovery had come after the worst recession in a lifetime.

Now, however, the Federal Open Market Committee (FOMC) is likely to announce at the conclusion of its Dec. 14-15 meeting that it’s going to taper at twice the speed, until those purchases eventually hit zero in March 2022, months earlier than initially planned.

The move is unprecedented and experts say it illustrates more ominous undertones about the U.S. economy. Officials at their December meeting are still expected to keep short-term interest rates unchanged at near-zero percent — though how long that lasts is the ultimate question.

“Interest rates are going to go up next year,” says Greg McBride, CFA, Bankrate chief financial analyst. “We don’t know how much or how many times, but they will go up. Now is the time to get in front of that.”

Here’s three things you need to know about the Fed’s next meeting and how it could impact you.

1. Highest inflation in nearly 40 years could force Fed to speed up taper

In the weeks leading up to the December meeting, officials across the entire Fed system talked about the strength of the U.S. economic recovery, all of them echoing concern that inflation’s imprint on virtually all items in consumers’ shopping carts might make it time to speed up taper.

Many of them were voting members on this year’s rate-setting committee, including San Francisco Fed President Mary Daly and Atlanta Fed President Raphael Bostic. New York Fed President John Williams said in a Dec. 1 interview with the New York Times that the central bank would have to “grapple” with ending those purchases “somewhat earlier.” Much to Fed watchers’ surprise, Powell in a Nov. 30 congressional testimony revealed that he shared those sentiments.

“At this point, the economy is very strong, and inflationary pressures are high,” he said. “It is therefore appropriate, in my view, to consider wrapping up the taper of our asset purchases, which we actually announced at our November meeting, perhaps a few months sooner.”

In the most likely scenario, experts say the Fed would speed up taper to $30 billion a month, up from the previous $15 billion. If the Fed were to finish tapering by March 2022, that might mean U.S. central bankers have room to hike interest rates three or four times in the year.

“The objective here is to clear the runway and allow the Fed to begin raising rates sooner if that proves to be warranted,” says Steve Friedman, senior macroeconomist at MacKay Shields who formerly worked for the New York Fed. “This opens the door to quarterly rate increases beginning in June, if not March, when taper comes to an end.”

Keep an eye on Fed’s interest rate projections released this month

Officials will likely try to prime markets for those plans in updates to their quarterly “dot-plot” chart, which tracks officials’ interest rate projections. That rate-hike path is not set in stone, meaning consumers shouldn’t take it as gospel, but it could still give an indication into how hawkish officials are becoming.

Last September, for example, half of Fed officials still saw rates still holding at zero in the year. And last March, the median forecast among officials saw rock-bottom rates persisting through 2023.

“It’s a reflection of how we sped through the early stages of this recovery, and inflation pressures have been much more intense than policymakers had anticipated,” Friedman adds. “They’re now looking at a scenario where inflation doesn’t look like it’s going to moderate next year as much as they hoped it would.”

2. Fed must figure out how to get inflation under control

Prices aren’t just soaring, but those increases are broadening out, spreading beyond just the pandemic-ravaged areas of used cars, airfares, as well as hotel and ticket prices, to rents, housing, groceries, gasoline and apparel.

Days after the Fed’s November meeting, a report from the Department of Labor showed that consumer prices in October soared 6.2 percent from a year ago, the fastest annual increase in 30 years. Then on Friday, the same gauge showed that prices rose in November by an annual pace of 6.8 percent, the fastest increase in almost 40 years.

The Fed in November broadly saw that most of the price pressures came from supply-side restraints, challenges that monetary policy cannot meaningfully alter. That picture, however, could be changing. A separate report — the Bureau of Labor Statistics’ employment-cost index — reported that third-quarter worker compensation rose at the fastest pace since 2003 (1.3 percent) from the prior three months, playing into fears of a wage-price spiral.

“Almost all forecasters do expect that inflation will be coming down meaningfully in the second half of next year,” Powell told lawmakers two weeks before the Fed’s meeting, adding that he no longer wants to characterize inflation as “transitory.” “The point is we can’t act as though we’re sure of that.”

Fed officials have been patient about raising interest rates in the face of higher inflation because they’re implementing a new policy framework, one that lets inflation average out at 2 percent over time and helps unemployment fall even further. Powell, however, also told lawmakers that the Fed’s 2 percent average inflation target “has been met now.”

“They’ve been fooled by inflation,” McBride says. “It’s not being transitory, and it has hit the American consumer much harder than expected. Go back to say June, and 80 percent of the increase in the consumer price index (CPI) came from four things. That’s not the case anymore.”

That’s not to say the labor market has fully recovered. Some 2.3 million workers are still missing from the labor force, and employers have only recovered about 83 percent of the 22.4 million jobs lost during the worst of the pandemic.

Progress, however, is continuing. Unemployment fell in November to 4.2 percent, and 594,000 more people came off the sidelines to work. That should help alleviate labor force participation pressures, some of which might be to blame for employers adding a meager 210,000 new payrolls to their books last month — a huge miss, and half of what economists had expected in their forecasts.

“It’s always a matter of balance,” says Dan North, chief economist at Euler Hermes. “They have to get in front of inflation. If you let inflation run away, it gets that much more difficult to contain, and you have to get more aggressive with monetary policy, which is harder on the economy.”

Yet, the latest employment data is also telling Fed officials that the labor market might be tight, and inflation could end up hurting those who remain on the sidelines.

“If we didn’t have higher inflation readings, you might let the economy go a little bit more to see if we can get through COVID and have those [unemployed] individuals come back,” Daly said during a Dec. 2 webinar. “But the same people who might be sidelined and not getting jobs, they’re also paying higher prices. And inflation is a pretty regressive tax.”

3. How will the Omicron variant impact the economy and Fed’s plans?

The Fed’s plans to end stimulus sooner than expected could also be derailed by the ongoing pandemic, particularly amid a rise in Omicron variant cases that’s already making markets and consumers jittery.

On the one hand, the virus could weigh on employment, especially if fewer consumers leave their homes. On the other hand, more lockdowns could exacerbate inflation and associated supply-chain problems. Both outcomes could put the Fed between a rock and a hard place.

Still, experts say the virus is unlikely to completely derail the Fed’s taper plans — barring any new restrictions or lockdowns that could alter the economy’s rebound. Much of that can be inferred by looking at the way Powell handled the Delta variant.

“With successive waves of COVID over the past year, there has tended to be less in the way of economic implications from each wave,” Powell said after the Fed’s July press conference, as new virus cases soared. “We’ve kind of learned to live with it. A lot of industries have improvised their way around it.”

Experts also say higher inflation means the Fed doesn’t have room to be as patient with its stimulus-drawdown plans as the economy faces a new virus-related threat.

“They’re much more concerned about inflation and less willing to sit out during an entire new wave of the virus,” Friedman says. “Inflation wasn’t particularly strong then when the Delta variant came around; the Fed could afford to be patient.”

Higher rates are likely on the way: Take steps to prepare now

With interest rates expected to go up next year, consumers will want to take action to ensure that higher borrowing costs aren’t saddling them.

That’s especially true for those who have high-cost debt, such as credit card or personal loan balances. They will want to consider combining that debt to reduce interest rates and monthly payments with a balance-transfer card or personal consolidation loan. Refinancing variable-rate loans into a fixed rate might also be a wise idea.

As the Fed buys fewer bonds, all signs point to higher mortgage rates, especially as inflation begins to rise. For those who haven’t yet refinanced — which 74 percent of homeowners in an October Bankrate survey said they hadn’t done — now’s the time. Mortgage rates have increased in recent weeks, though still holding near historic lows.

Investors should consider allocating some inflation-safe investments into their portfolios, such as Treasury Inflation Protected Securities (TIPS) or real-estate investment trusts (REITs), and avoid keeping too much of their money in fixed-income investments. Consumers hoping to minimize their impact on inflation, however, are running out of places to hide, as price increases stretch into virtually all corners of the marketplace.

All the while, those with money in the market might want to remain calm in the face of any volatility, maintaining a long-term mindset and avoiding any knee-jerk reactions. That might happen as the Fed begins to renormalize policy at a faster pace — and especially so as inflation defies the Fed’s expectations, raising questions about officials’ credibility.

“The Fed is responding to incoming data just the same as everybody else; they don’t have a crystal ball,” McBride says. “The more important issue the Fed has to deal with is balancing a level of accommodation with what is needed to sustain economic growth and improved labor market conditions. If they raise rates too much or at the wrong time, we can end up with a recession in 2023, but if they get it right, it can prevent a crazy asset bubble [from popping] that leads to a sharp contraction later. The stakes are high.”

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