The flurry of data releases around the turn of the year have made it abundantly clear that the Federal Reserve has a fair bit of catching-up to do in 2022.
Headline consumer prices rose by 7% in 2021, the most since 1982. Above consensus readings on core inflation came in at 5.5% for December, the biggest increase since 1991. The ongoing pandemic has contributed to supply-chain bottlenecks and labor shortages, even as demand, buoyed by higher household savings, remains strong. While food and energy costs have risen in the past year, core inflation has been driven by higher prices for shelter, vehicles, apparel and several other categories. Wages, home prices and rents have seen robust increases. Meanwhile, there are concerns that the tight labor market, with the jobless rate at 3.9% suggesting a state close to full employment, will continue to fuel wage pressures. Yet, wage growth is being outpaced by price increases, thus eroding purchasing power. Thus, the breadth and pace of inflation gains are cause for concern for policy makers and investors alike.
Against this backdrop, the Fed is expected to redouble its efforts at monetary policy tightening. The January 5th release of the December 15th FOMC meeting minutes revealed Fed officials were looking to withdraw monetary accommodation via the ongoing tapering of bond purchases by mid-March and then proceeding to raise rates sooner and faster than earlier anticipated. There was also discussion of the Fed reducing the size of its $8.8 trillion balance sheet as an additional tightening measure.
Clearly, the sequence of QE (quantitative easing), lift-off (initiation of rate hikes) and QT (quantitative tightening via balance sheet shrinkage) has been top-of-mind for policy makers but the latest economic data have led to expectations of a more aggressive pace and timing of monetary policy adjustments. The resulting market repricing since the beginning of this year has seen US bond yields rise across the curve.
Latest post-CPI (Consumer Price Index) comments by Fed officials such as James Bullard and Lael Brainard suggest four rate hikes in 2022 starting in March are highly probable, compared to expectations of only three hikes just a month ago. There are growing expectations of Fed balance sheet runoff commencing soon after lift-off. The swift removal of QE and the onset of QT have strong implications for all asset classes as liquidity is drained, but fixed income markets in particular are expected to see higher volatility as the Fed pares its holdings of Treasury and mortgage-backed securities.
In addition to the likelihood of the Fed being more aggressive in the pace and timing of contractionary policy measures is the question of what the terminal rate is going to be — in other words, at what level will the Fed funds rate peak when the central bank’s hiking cycle is done? The median forecast of FOMC members as of December called for a terminal rate of 2.00-2.25% by 2024, and the market is currently pricing that terminal rate at roughly 1.75%. However, given the latest data releases and policy maker comments, this may now seem inadequate.
At the same time however, we are living in the throes of a prolonged pandemic in which Covid’s successive variants have raised uncertainties about economic activity and growth in general. If growth stalls and sentiment worsens, the Fed runs the risk of choking off the recovery with aggressive tightening. This further complicates the Fed’s already challenging task of reining in inflation that has been soundly exceeding expectations. All said and done, 2022 is primed for more volatility and hence more alpha opportunities in fixed income relative value strategies as policy makers and investors adapt to a rapidly evolving macro landscape.