The Federal Reserve said Wednesday that it will halt crisis-driven asset purchases early next year, setting the stage for three interest-rate hikes in 2022 to help counter the threat of persistently high inflation. The stock market, which was lower as investors braced for Fed meeting news, turned higher after the policy news. As Fed chief Jerome Powell answered questions, the Dow Jones, S&P 500 and Nasdaq turned solidly higher.
The immediate takeaway is that stock market investors are feeling more sure that the Fed won’t let inflation take off, but won’t have to tighten too quickly. Fed economic projections suggest that policymakers see “Goldilocks” conditions in 2023.
Federal Reserve Rate-Hike Outlook
Quarterly Fed economic projections showed that 12 policy committee members, out of a total 18, think conditions will warrant at least 3 quarter-point rate hikes in 2022. That’s quite a shift from September’s projections. At the time, nine of 18 Federal Reserve policymakers thought it would make sense to wait until 2023 for the cycle’s first rate hike.
In addition, a majority of 11 policymakers anticipate 3 further rate hikes in 2023. That would lift the Fed’s benchmark overnight lending rate to a range of 1.5%-1.75% vs the current 0%-0.25% range.
The outlook implies that the Fed will start hiking its benchmark rate probably by next June and continue hiking once a quarter through 2022. But the outlook for just three hikes in 2023 implies that the pace will slow.
Faster Fed Taper
On Nov. 3, the Federal Reserve announced it would gradually wind-down asset purchases from the $120 billion monthly pace. The initial steps down of $15 billion per month would have had purchases of Treasuries and mortgage securities wrap up by June.
But on Wednesday, the Fed elected to speed up its exit from the extraordinary policies it adopted early in the pandemic. Asset purchases will now decrease by $30 billion per month and likely come to an end in March.
That timing is significant because the Fed has long signaled it would hold its key interest rate steady until after it halts its nonconventional balance-sheet expansion. That means interest-rate hikes could be on the table as early as March.
A key question will be what happens to extra $4.5 trillion in assets on the balance sheet after the taper is over. As those Treasury and mortgage securities mature, the Fed faces a choice of whether to let its balance sheet shrink or to roll over the principal, as well as interest, into new purchases.
At his postmeeting press conference, Fed chief Powell said policymakers began to discuss that this week and could make a decision in upcoming meetings. While no details were offered, he did offer stock market investors some comforting words.
When it comes to the balance sheet, it’s “best to take a careful, methodical approach,” Powell said. “Markets can be sensitive” about it.
The last time the Fed shrank its balance sheet amid interest-rate hikes, the stock market had a bear-market scare in late 2018. That forced the Fed to call it off and resume balance sheet growth in 2019.
Stock Market Rallies After Fed Meeting
After the Fed meeting policy news, the stock market turned higher, after being in the red most of the day. Stocks accelerated during and after Powell’s press conference.
The Dow Jones industrial average closed up 1.1%, while the S&P 500 jumped 1.6%. The Nasdaq composite, which has had a lousy week as investors weigh the implications of a more aggressive Fed, erased losses and ran up 2.15%.
Though Fed policy signals were much more hawkish than in September, they were still somewhat more aggressive than stock market investors were expecting.
After the Fed policy news, the 10-year Treasury yield rose two basis points to 1.46%, not far off 12-week lows.
Ahead of the Fed meeting decision, CME Group showed 62% odds of three Fed rate hikes by December 2022.
Recent Fed hawkishness has pushed up short-term Treasury yields, while long-term Treasury yields have eased back. That suggests investors see a risk of the Fed acting too aggressively, which will have longer-term disinflationary effects.
The flattening Treasury yield curve helps explain why bank stocks have struggled lately, while the overall stock market — and especially tech stocks — had fared better until this week. Since banks borrow at short rates and lend at long rates, their net interest margins are squeezed when the yield curve flattens.
Meanwhile, growth-stock valuations tend to be helped by a lower 10-year Treasury yield, which is used to discount future earnings back to the present.
Yet concern that the Fed may act too aggressively to contain inflation pressures isn’t conducive to growth-stock valuations either.
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Omicron Wild Card
In testifying to Congress two weeks ago, Fed chief Powell first raised the possibility of a faster taper. Yet Powell indicated that his his more hawkish outlook didn’t yet incorporate the emergence of the omicron Covid variant.
Then, as early evidence showed the omicron variant appears relatively mild, the stock market took off last week.
The implication: Even though Fed asset purchases are often seen as fuel for higher stock prices, stock market investors aren’t especially worried about a faster taper.
Powell also suggested that the omicron variant might contribute to inflation pressures, as policymakers believe the delta variant has. That could happen by keeping would-be jobseekers on the sidelines, keeping pressure on wages and supply chains.
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How Close Is Full Employment?
Will Goldilocks conditions prevail in 2023 and 2024, as the Fed economic projections suggest? A key question is whether the Fed is right about its labor market outlook. Policymakers see the unemployment rate falling from 4.2% currently to 3.5% by the end of 2022 and staying at 3.5% through the end of 2024.
However, Aneta Markowska, chief economist at Jefferies, sees the jobless rate tumbling to 3% in 2022, keeping pressure on wages.
The labor force — everyone either working or actively seeking a job — is down by 2.4 million since February 2020. That’s despite the working-age population (16 and up) growing by 2.4 million over the same period.
But there’s less labor market slack than meets the eye, because the senior population has ballooned by 3 million as the oldest baby boomers turn 75.
Labor force participation typically drops to about one in five among older workers. Covid-related risk and a boom in the stock market and real estate wealth may be giving older Americans more reasons to retire or stay retired.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
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