Federal Reserve Chairman Jerome Powell
Kevin Dietsch/Getty ImagesMinutes from the Federal Reserve’s December policy meeting underpin officials’ hawkish pivot and suggest earlier and faster rate increases in addition to a quicker start to normalizing the central bank’s massive balance sheet—itself a form of policy tightening.
The meeting minutes, released Wednesday afternoon, follow the Dec. 15 meeting where policy makers signaled three rate increases this year and three the following year as inflation concerns deepened. After months of describing pricing pressures as “transitory,” the Fed dropped the term and spooked investors with new concerns just as a new variant of Covid-19 emerged. Fed Chairman Jerome Powell shifted his tone to emphasize the ongoing pandemic’s risks to inflation, via ongoing supply-chain issues, as opposed to growth.
Minutes from the meeting give investors more context into officials’ latest discussions. Participants “generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated,” the minutes say. Several participants, meanwhile, “viewed labor market conditions as already largely consistent with maximum employment.” Taken together, those passages suggest the first rate increase could come as soon as March.
“Given the twin concerns of rising inflation and potential for negative growth surprises, you can see why they have urgency in completing their tapering as soon as possible, while still leaving optionality for the timing of the first rate hike,” says Chris Zaccarelli, chief investment officer for Independent Advisor Alliance.
At the same time, Fed officials began discussing how to start shrinking its almost $9 trillion balance sheet, which ballooned by about $4 trillion since the start of the pandemic and represents roughly 40% of U.S. gross domestic product. Some economists say how the Fed handles balance-sheet normalization may be more consequential for markets than the timing and pace of rate increases.
“Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience,” the minutes say, with officials noting that current conditions included a stronger economic outlook, higher inflation, and a larger balance sheet and thus could warrant a potentially faster pace of policy rate normalization.
Relative to the last round of balance sheet runoff, which was under way before the pandemic struck, “this is fast and furious normalization,” says Omair Sharif, president of Inflation Insights LLC. Sharif says the discussions around not just the appropriate size and composition of the balance sheet, but also the timing of the runoff, is much more detailed than many investors probably expected.
Stocks sank after the relatively hawkish set of meeting minutes. The S&P 500 fell 1.3% while the more rate-sensitive Nasdaq dropped 2.5%.
Post-minutes, many economists and strategists say the Fed is likely to raise interest rates quicker and shrink its balance sheet sooner than investors have expected. What is harder to forecast, says Zaccarelli of Independent Advisor Alliance, is the level of market despair officials are willing to tolerate before changing course.
“Is it 15%? or 20%? We believe the Fed will endure some short-term volatility in the stock market in order to remove all of the monetary accommodation they’ve injected into markets,” says Zaccarelli. However, he says, they are still likely to heed warnings of recession from the stock market—say a drop of 20%—and would pause their activities in that event.
For now, investors are facing the reality of policy normalization. There will have to be a lot more pain before markets scare the Fed off.
Write to Lisa Beilfuss at lisa.beilfuss@barrons.com
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