If all goes as planned, the Federal Reserve will raise interest rates for the first time in three years in a little more than two months, a move that policymakers believe is inevitable and that markets and the economy are reluctantly accepting.
The Fed recently raised interest rates in late 2018, as part of a “normalization” process that occurred as the United States’ longest-running economic expansion came to an end.
Only seven months later, the central bank retreated as the expansion appeared to be fraying. Eight months after the initial drop in July 2019, the Fed was obliged to reduce its benchmark borrowing rate all the way to zero as the country faced a pandemic that put the global economy into an unexpected and devastating tailspin.
As regulators prepare to return to more traditional monetary policy, Wall Street is keeping a tight eye on the situation. In the middle of the gyrations that have welcomed the Fed since it signaled a policy pivot a month ago, the first trading day of the new year revealed that the market is willing to keep pushing upward.
“When you look back historically on the Fed, it’s usually multiple tightenings before you get in trouble with the economy and the markets.”Jim Paulsen, Chief Investment Strategist at The Leuthold Group
Paulsen expects the market will accept the first hike – likely to be implemented at the March 15-16 meeting – with little fanfare because it has been widely anticipated and will still just raise the benchmark overnight rate to a range of 0.25% to 0.5%
“We’ve developed this attitude on the Fed based on the last couple decades where the economy was growing at 2% per annum, and in a 2% stall-speed economy world, if the Fed even thinks about tightening it’s damaging. But we don’t live in that world anymore.”Jim Paulsen
At their December meeting, Fed officials planned two more 25-basis-point hikes before the end of the year. A basis point is one-hundredth of a percentage point.
According to the CME’s FedWatch Tool, current pricing in the fed funds futures market indicates a 60% chance of a rise in March and a 61% chance that the rate-setting Federal Open Market Committee would add two more by the end of 2022.
The ensuing raises are where the Fed may face some pushback.
The Fed is raising interest rates in response to inflationary pressures that are running at the strongest rate in nearly 40 years, according to certain measurements. Chairman Jerome Powell and the majority of policymakers spent much of 2021 arguing that prices would fall short, but by the end of the year, they admitted that the pattern was no longer “transitory.”
Creating a landing
According to Mohamed El-Erian, senior economic advisor at Allianz and chair of Gramercy Fund Management, how markets react to rate hikes will be determined by the Fed’s ability to manage an “orderly coming down.”
“The Fed gets it just right and demand eases a little bit, and the supply side responds. That is sort of the Goldilocks adjustment.”Mohamed El-Erian, Senior Economic Advisor at Allainz & Chair of Gramercy Fund Management
However, he warned that the risk is that inflation lingers and rises even faster than the Fed expects, necessitating a more forceful reaction.
“The pain is already there, so they are having to play massive catch-up, and the question is at what point do they lose their nerve.”Mohamed El-Erian
Bond yields, which are expected to provide early hints about the Fed’s plans, are being closely monitored by market experts. Despite expectations for rate hikes, yields have been relatively stable, according to Paulsen, but he anticipates a reaction that could push the benchmark 10-year Treasury to about 2% this year.
At the same time, El-Erian stated that he expects the economy to do rather well in 2022, even if the market encounters some challenges. Similarly, Paulsen stated that the economy is strong enough to absorb rate increases, which will raise borrowing rates across a broad range of consumer products. However, he believes a correction will occur in the second half of the year as interest rates continue to rise.
However, Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, believes that market volatility will become more prominent even as the economy grows.
Markets are coming off a period of “long decline in real interest rates, which allowed stocks to break free from economic fundamentals and their price/earnings multiples to expand,” Shalett said in a report for clients.
“Now, the period of declining fed funds rates which began in early 2019 is ending, which should allow real rates to rise from historic negative lows. This shift is likely to unleash volatility and prompt changes in market leadership.”Lisa Shalett, Chief Investment Officer at Morgan Stanley Wealth Management
When the minutes of the December FOMC meeting are released on Wednesday, investors will get a closer look at the Fed’s reasoning. The market will be particularly interested in comments not only regarding the speed of rate hikes and the decision to taper asset purchases, but also about when the central bank will begin to reduce its balance sheet.
Even while the Fed aims to stop buying in the spring, it will continue to reinvest the proceeds of its present holdings, keeping the balance sheet at its current $8.8 trillion level.
According to Citigroup analysts Andrew Hellenhorst, balance sheet reduction will begin in the first quarter of 2023.
Information from CNBC