The Fed is set to pave the way for a first rate hike in March and could provide details of plans to shrink its balance sheet.

Thomas Costerg, Pictet Wealth Management.

At the end of this week’s Federal Open Market Committee (FOMC) meeting, the Federal Reserve is likely to signal its intention to hike rates at the next meeting in March.

The Fed seems disorientated by persistently high monthly inflation prints and a tight labour market. The Omicron variant could have a net inflationary effect due to additional supply-chain disruptions (and a limited hit to consumer demand). Fed anxiety could remain high in the coming weeks as more data come through.

Calls are growing within its leadership to accelerate monetary tightening. A surprise at the January meeting would be to see the Fed abruptly calling an end to its monthly bond purchase programme, currently scheduled to end in March if it is really intent on shrinking its balance sheet early. At the same time, the Fed has long sought to avoid “rocking the boat” and to take a more ‘gradualist’ approach. All in all, the post-meeting press conference will be monitored for signals about the timing and potential extent of the future balance-sheet runoff.

Bottom line, we think the Fed will indicate that a 25 bps rate hike is coming at its March meeting, with a 40% probability that QE is ended in February instead of March. In 2022, we think the Fed will stick to a predictable, gradualist approach to rate hikes. We also think that the Fed’s balance sheet shrinkage will remain passive—in other words, bonds will just be let mature rather than actively sold, but with a cap to monthly redemptions.

In the long run, we believe the Fed will be judged not by its ability to move rates up but by its capacity to avoid having to cut nominal rates all the way back to zero again and restart QE when the first external shock hits in the coming years. This is far from being assured.