The Federal Reserve raised its benchmark interest rate for the first time in a year, but it's already time for the market to look past it, according to Kathy Bostjancic, chief U.S. economist at Oxford Economics.
The most important issue for the Fed is that economic growth remains strong. If the Fed is hesitant about raising rates and reducing the balance sheet because of war, there is a chance that it will be behind on inflation. Consumers are still sitting on a high level of savings and benefiting from rising wages, and if the Fed waits it will only increase the risk of the central bank becoming more hawkish later on.
The Fed forecast six more rate hikes and its view of inflation moved up considerably, with a forecast now above 4% this year.
There are risks on both sides of the Fed equation. If the financial markets are sent into a convulsion if it is too hawkish and tightens too quickly, there will be a mass selling of risk assets which feeds back into the real economy. The narrowing of the spread between the two-year and 10-year treasuries in the bond market has raised fears of an inverted yield curve, which is a signal that this worst-case, recessionary scenario could play out.
The yield rose to their highest level since 2019.
Even if she says the Fed won't be blind to these signals, the recession isn't the base case for her.
During recent testimony, Fed Chair Powell indicated that he sees inflation running a little faster than the Fed had expected, and any adjustment from the Fed is significant. The Fed matched her view of the inflation outlook into the meeting, which was much higher than the median forecast of 2.7% year over year through Q4 2022, closer to 4% than 3%. Her view is based on a labor market that is strong and a consumer that is resilient, and the Fed being behind the curve on inflation.
She said that the Fed has to worry about inflation. We are talking about more than 3%. It is close to 8%. This is a huge overshoot.
A trader works, as Federal Reserve Chair Jerome Powell is seen delivering remarks on screens, on the floor of the New York Stock Exchange (NYSE), January 26, 2022.The Fed's economic projections for GDP and inflation will need to be absorbed by the market, and the Dow initially fell after the announcement, but rebounded. Powell frames the Fed thinking on Wednesday that matters most.
I want to know how he handicaps the risks of growth and inflation. That will tell me about the Fed's reaction function and forward guidance.
After the official announcement, Powell said that the risk of inflation remains to the upside. Wage gains are showing signs of moderation, even though Powell doesn't see signs of a wage-price spiral. According to the Fed's latest forecast, the unemployment rate is expected to end the year at 3.5%.
Food prices have double the weight of energy in the consumer price index and loom as an even larger factor. Russia's invasion of Ukraine will have a cascading effect on the global supply chain and food prices will go up even more.
Powell said rate hikes are coming despite the war.
Oxford Economics is in line with a market view of 175 basis points of total tightening by the Fed this year, but isn't sure whether those hikes remain limited to 25 basis points or include the potential for a 50 basis point hike at some point. James Bullard, a member of the St. Louis Fed, voted for a hike in the federal funds rate.
The Fed needs to get to a neutral rate as quickly as possible without destabilizing the market because the economy is strong enough and demand is still strong.
She said that the situation is not dramatically different for the U.S. The U.S. economy is not immune to war, but it is better insulated than Europe's.
The Fed lowered its GDP outlook for the year from 4% to 2.8%, with the war in Ukraine being cited as a factor, while the central bank anticipates higher inflation and more rate hikes to combat it.
Powell will need to give a view on how the war will affect the U.S. economy and the market will be looking for any signals from the Fed chair.
In the end, the Fed has to come in. Even if there is a knock-on effect in supply chains, it can't control the war.
There is no way for a central bank to project the potential for a truce in a war.
Even though the euro zone's central bank held rates, it said it would wind down its monetary policy sooner than later.
The war could delay the Fed's balance sheet runoff, but by a month or two, and in her view, it should not affect the general path of normalization of both rates and the Fed's holdings in the bond market.
In his press conference, Powell said that the Fed was moving ahead with the balance sheet reduction plan. He said that the balance sheet unwind could begin at the next meeting in May.
He said that the framework will look familiar to people who have seen it before.
The recent flow of data has reinforced that the inflationary pressures are still widespread and elevated, and the Fed needs to raise rates and has the ability to do so.
Powell said in his press conference after the rate hike announcement that the risk of recession isn't particularly elevated and the economy is strong. Powell noted that the median inflation projection for the year is 4.3%, and the forecast through 2024 is higher than previous Fed projections.
Powell said that he was confident that they would use their tools to bring inflation down.
The market has already priced in an aggressive rate hike profile, and the market was not expecting the Fed to tell it to price in less than it already has. She said it was doing the work for the Fed.
The Fed agreed with that view on Wednesday.
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