It was as if a rescuer was rushing to the scene of an accident. The Federal Reserve took less than two weeks to cut interest rates to zero and unveil its largest bond buying program in history when the coronavirus pandemic entered the economy.
But today, as inflation hits its highest level in 40 years and millions of people remain on the margins of the workforce, U.S. central bank officials have been caught in the midst of a much larger turnaround. slow.
Officials kicked off 2021 with plans to keep interest rates low for at least two more years and have viewed high inflationary pressures as a temporary failure in a financial system recovering from a pandemic. However, they are now set to kick off a new era for Fed policy in 2022 that could include up to three rate hikes – according to officials’ most recent projections – and an earlier than expected end of the billion. from the Fed. dollar asset purchase program.
“Central bankers usually wage the last war,” says Vincent Reinhart, chief economist and macro-strategist at Dreyfus and Mellon, who previously spent 24 years at the Fed. âIn the last war inflation was never a problem and you could heat up the job market so they went into this war saying you can’t provide too much stimulus and inflation wouldn’t be a problem. They worried about the bad fight.
The Fed now sees inflation as the biggest threat to the US economy
Inflation skyrocketed in 2021, with consumer prices in November rising 6.9% from a year ago, the fastest pace since 1982. A measure of Americans’ confidence in the US economy plunged to its lowest level in a decade as price pressures erode their purchasing power.
Some metrics suggest investors are starting to expect high prices to be here to stay, although those expectations have eased from their record highs as market players grapple with slowing growth. and the rapid spread of the Omicron variant.
Fed Chairman Jerome Powell echoed those sentiments at a post-meeting press conference in December, suggesting that the Fed’s hawkish pivot is supposed to put U.S. central bankers in a defensive position. Officials see high inflation persisting until at least 2024, with the personal consumption expenditure price index ending in 2021 at 5.3%, although it moderates to 2.6% at the end of 2022.
“We need to make policy now, and inflation is way above target.” said Powell. “If we only knew [labor force participation] would start to increase in two years, would we wait two years when inflation is well above target? Probably not. What is the maximum employment level compatible with real-time price stability, that’s one way of thinking. “
For months, the Fed’s mantra has been that inflationary pressures will ease once the US economy gets past the pandemic. Supply pressures have led to good shortages, and officials have seen a persistent gaping hole in the U.S. workforce, with nearly 2.3 million workers still missing. The Fed took this as a sign that the job market might not be as tight as some measures suggest, and once the virus cases are gone, they will have an incentive to return to work.
Instead, Powell admitted in December that employment cost reports showing emerging wage pressures appeared to prove the Fed wrong, while monthly readings showed inflation continued to climb. Meanwhile, subsequent waves of the virus from Delta to Omicron have proven to officials that the virus could be a permanent fixture in the economy, leading them to believe that a shrunken workforce is here to stay – just like high inflation if officials don’t act fast enough.
“This is the realization that we are going to have to live with this virus,” said Rhea Thomas, senior economist at Wilmington Trust. “The implications are that the virus can worsen supply chain disruptions and worsen labor market participation, and the Fed will have to pivot to this new normal and live with that friction.”
Authorities slow down asset purchases to raise interest rates for 2022
Economists say rates will inevitably rise next year, but the question is when and how often.
Part of it depends on the Fed’s asset purchase program. The Fed won’t want to raise rates while it still buys a massive amount of mortgage-backed securities and Treasuries. This is because the purchase of assets stimulates the economy, while the rise in rates hits the brakes on the financial system.
Still, officials announced in December that they would start buying $ 30 billion less bonds per month, the second adjustment to the Fed’s stimulus withdrawal known as the “taper.” Given this pace, the Fed would close its bond purchases entirely by March 2022, potentially opening the door to rate hikes as early as its March 16 meeting – or those to follow in May or June.
“One has to happen followed by the other,” said Joseph Mayans, senior economist and founder of Advantage Economics, whose baseline scenario for 2022 is two rate hikes starting in June. This is mainly because of “some of the unknowns in the economy: the Omicron variant, how households deal with less stimulus.” This will be the dichotomy throughout 2022: what the Fed sets out to do and what it will be able to accomplish. “
Economists say viral variants such as Omicron are unlikely to bring back restrictions similar to March 2020 through vaccinations. Powell also said in December that the new wave of infections is unlikely to derail the Fed’s plans to reverse stimulus altogether.
âBringing the end of our taper forward a few months is really an appropriate thing to do, and I think Omicron has little to do with it,â said Powell.
The virus, however, could exacerbate supply chain and employment problems, complicating the Fed’s policy making. In an economy ravaged by viruses, the evolution of Fed rates is subject to even more uncertainty than usual and the rise in interest rates in 2022 depends on the evolution of inflation and the virus .
“They’re going into defense mode,” says Thomas. âAt the moment, they are not really taking away housing; they’re trying to release the accelerators. They go out and prepare to become hawkish if they need to.
At the end of the line
It’s a tricky juggling act for the Fed, which won’t want to risk removing hosting too soon – or being too late for the party.
The Fed knows that raising interest rates too early risks slowing the economy unnecessarily, leaving millions of Americans unemployed who would otherwise have found jobs if the financial system had had a little more time to settle. develop. But letting the economy run too fast could risk overheating the economy. Meanwhile, declining purchasing power due to inflation could also slow consumer spending and hiring. Getting it right is part of the reason Fed officials have come so late to the rate hike party.
âThe fares go up by the escalator and down by the elevator,â says Reinhart. âPolicy easing tends to be a response to bad news. You get bad news, you react. Policy tightening tends to be more planned. You anticipate emerging inflationary pressures, give advance warning to raise rates, and increase rates gradually. â¦ It’s going to be a tough year, and if you thought 2021 was tough for the Federal Reserve, 2022 could be even more difficult.