The Marriner S. Eccles Federal Reserve Building in Washington.
Stefani Reynolds / Bloomberg via Getty Images
If all goes according to plan, the Federal Reserve will proceed in just over two months with its first rate hike in three years, a move that policymakers believe is necessary and that markets and the economy are starting to reluctantly accept.
The Fed last hiked rates at the end of 2018, as part of a “normalization” process that occurred during the longest period of decline in economic expansion in states’ history. -United.
Just seven months later, the central bank pulled back as the expansion looked increasingly fragile. Eight months after that initial cut in July 2019, the Fed was forced to reduce its benchmark borrowing rate to zero as the country faced a pandemic that plunged the global economy into a sudden and shocking plunge.
As officials brace for a return to more conventional monetary policy, Wall Street is watching closely. The first trading day of the new year signaled that the market was poised to continue pushing higher, amid the gyrations the Fed has greeted since it indicated a political pivot a month ago.
“When you look at the history of the Fed, it’s usually several times before you have problems with the economy and the markets,” said Jim Paulsen, chief investment strategist at Leuthold Group.
Paulsen expects the market to accept the initial hike – which is expected to be enacted at the March 15-16 meeting – without much fanfare, as it was well telegraphed and will still carry the benchmark overnight rate. day to a range of 0.25% to 0.5. %.
“We developed this attitude towards the Fed based on the past two decades where the economy was growing at 2% per year,” Paulsen said. “In an economic world with 2% stall speed, if the Fed even thinks of a tightening, it is damaging. But we no longer live in this world.”
Fed officials at their December meeting forecast two more 25 basis point hikes before the end of the year. One basis point is equal to one hundredth of 1 percentage point.
Current prices in the federal funds futures market indicate an approximately 60% chance of a March hike, and a 61% chance that the federal rate-setting committee will add two more by the end of this year. 2022, according to CME’s FedWatch. Tool.
These subsequent hikes are where the Fed may experience a backlash.
The Fed is raising rates in response to inflationary pressures which, by some measures, have been at the fastest pace in nearly 40 years. President Jerome Powell and most other policymakers spent much of 2021 insisting that prices would drop soon, but conceded towards the end of the year that the trend was no longer “transient.”
The Fed’s ability to orchestrate an “orderly cut” will determine the reaction of markets to rate hikes, said Mohamed El-Erian, chief economic adviser at Allianz and chairman of Gramercy Fund Management.
In that scenario, “The Fed gets what it takes and demand goes down a bit and supply reacts. It’s sort of the Goldilocks adjustment,” he said on Monday. CNBC’s Squawk Box.
However, he said the danger is that inflation will persist and rise even more than the Fed anticipates, prompting a more aggressive response.
“The pain is already there, so they have to catch up, and the question is when do they lose their temper,” El-Erian added.
Market veterans are watching bond yields, which should point to leading clues to the Fed’s intentions. Yields have remained largely under control despite expectations for rate hikes, but Paulsen said he expects to see a reaction that could ultimately take the benchmark 10-year Treasury to around 2% this year.
At the same time, El-Erian said he expects the economy to do quite well in 2022, even if the market faces headwinds. Likewise, Paulsen said the economy is strong enough to withstand rate hikes, which will increase lending rates on a wide range of consumer products. However, he said he expected a correction to come in the second half of the year as rate hikes continued.
But Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said she believes the market turmoil will be more pronounced even if the economy grows.
Markets are emerging from a prolonged period of “long declines in real interest rates, which allowed stocks to break free from economic fundamentals and grow their price / earnings multiples,” Shalett said in a report to clients .
“Now, the period of lower federal funds rates that began in early 2019 is ending, which should allow real rates to rise from historic negative lows. This shift is likely to trigger volatility and rapid changes. market leadership, ”she added.
Investors will take a closer look at the Fed’s thinking later this week, when the minutes from the December FOMC meeting are released on Wednesday. Discussions about the pace of rate hikes and the decision to gradually reduce asset purchases, but also about when the central bank will begin to shrink its balance sheet, will be of particular interest to the market.
Even though the Fed intends to stop buying in the spring, it will continue to reinvest the proceeds from its current holdings, which will keep the balance sheet around its current level of $ 8.8 trillion.
Citigroup economist Andrew Hollenhorst expects the balance sheet reduction to begin in the first quarter of 2023.