Journey of the mighty Federal Reserve from a dovish to hawkish position

The US Federal Reserve has been entrusted with the mandate of regulating the banking system and ensuring financial stability for the American people. In doing so, the Federal Open Market Committee (FOMC), the monetary policy-making body of the Fed, periodically adjusts interest rates to align them with the evolving economic environment.

Economic activity expanded at a robust pace of 5.5% over the last year, the outcome of progress in vaccinations, reopening of the economy, fiscal and monetary policy support, and the healthy financial positions of households and businesses.

While the US economy continues to maintain strong fundamentals, the FOMC raised its policy rate by 0.25 basis points against the backdrop of an extremely tight labor market and high inflation. The committee is anticipated to announce further rate hikes over the course of the year. In addition, the Fed is also likely to commence the exercise of reducing the size of the balance sheet.

The median projection for the appropriate level of the federal funds rate has been pegged at 1.9% towards the end of 2022, a good percentage point revision when compared to its estimate a few months back. Over the next two years, the median projection has been pegged at 2.8%, though this looks a little stretched given the expected slowdown in global growth.

The big focal point for the Fed’s hawkish outlook has been the low unemployment level in the US, non-transitory inflation, and deteriorating outlook on inflation due to sudden surge in commodity prices and oil price. Further, the Russia-Ukraine conflict situation and surge in COVID-19 cases in China could add to supply chain woes and cloud the outlook on inflation.

Strong Jobs Growth

The labor market has continued to strengthen and over the first two months of the year, employment rose by more than one million jobs.

The unemployment rate hit a post-pandemic low of 3.8%. With widespread improvement in labor market conditions, FOMC participants expect labor market sentiments to remain strong. The positive sentiments have been reflected in the median projection for the unemployment rate declining to 3.5% by the end of this year and expected to remain near that level thereafter.

Inflation

The Federal Reserve has been caught off guard and is now playing catch up. Inflation has been a subject of significant worry not only for the Federal Reserve but also for other central banks. The Federal Reserve especially has got the inflation call wrong over the last several months with the assumption of it being transitory falling flat. The annual inflation rate measured by CPI for the United States is 7.9% for the 12 months ended February 2022—the highest since January 1982 and after rising 7.5% in January 2022.

Let us examine some numerical data to understand how the Fed erred on the inflation call. The annual inflation in 2020 was around 1.4% and while the US economy continued to remain in an inflationary mode in 2021 and 2022 till date, the Fed continued with its quantitative easing program, pumping billions of dollars into bonds and offering more and more liquidity which led to a sharp rally in risk assets globally.

The median inflation projection for 2022 is 4.3% which is expected to fall to 2.7% in 2023; this trajectory is notably higher than estimated projections in December 2021.

The Fed's communications were unmistakably hawkish on Wednesday, signaling a much stronger bias on part of the FOMC to raise rates aggressively this year to contain inflation.

The bond markets in the US had started discounting inflation since the middle of 2021. The 10-year bond yield has moved up from 1.22% in July 2021 all the way up to 2.13% yesterday. Also, the more notable part of the yield curve has been the US 2-year bond whose yield has moved up from 0.22% to 1.91%. The spread compression between 10 years and 2 years is a sign of worry as any sustainable inversion has been a precursor of recession based on past data.

A key question that needs to be answered in the current context is can the Fed tighten rates aggressively without hard lending? It also needs to be examined whether the Fed can afford a recession given the extraordinary growth in 2021 that was supported by strong fiscal stimulus.

With bond buying coming to a close and Fed hiking rates and balance sheet rates, it does not augur well from a growth perspective.