US central bank plans first increase since 2018 to combat rocketing inflation, currently at 7 per cent, the highest level since 1982.

US equities sold off yesterday after the  US Federal Reserve hinted that it will start to steadily put up interest rates in the middle of March, another step in its move to curb inflation that has rattled investors and the political world in recent weeks.

Jerome Powell, chairman of the central bank, said yesterday that the Fed was ready to raise rates at its March 15-16 meeting and could continue to lift them faster than it did during the past decade.

“This is going to be a year in which we move steadily away from the very highly accommodative monetary policy that we put in place to deal with the economic effects of the pandemic,” he said at a news conference after a policy meeting at the central bank. 

The direction of monetary policy is shifting. After more than 13 years of ultra-low interest rates and heavy quantitative easing after the 2008 financial crash, the tectonic plates of policy are moving. The Fed, along with its counterparts, engaged in fresh bouts of money printing when the pandemic hit two years ago. During 2020 alone, it is estimated that a quarter of all dollars in circulation had been printed that year. Coupled with supply disruptions caused by COVID-19 and associated lockdowns, and arguably aggravated by policies to reduce C02 emissions, prices for consumers and businesses have risen sharply. A big debate for wealth management asset allocators is whether inflation is a temporary phenomenon or something more enduring. Those old enough to recall debates from the “stagflation” era of the 1970s and part of the 80s know how painful the economic consequences can be.

For much of the past decade or more, asset allocation ideas have been bent out of shape by very low rates, thin yields on stocks and government bonds, and a push to private, less liquid, markets. The rise of cryptocurrencies is also perhaps a sign of how faith in government fiat currencies has waned. 

Whatever the longer-term picture for wealth managers, here are some comments about the Fed position.

Gurpreet Gill, macro strategist, global fixed Income, Goldman Sachs Asset Management
As expected, the Fed paved the way for a rate hike at its March meeting, acknowledging strength in inflation and the labor market. During the press conference, Chair Powell’s comments suggested upside risks to the median policymaker dot plot unveiled in December, which previously indicated three rate hikes this year.

The principles on balance sheet reduction confirm that the Federal Open Market Committee (FOMC) is actively reviewing its options but did not confirm the start date for an unwind of the $8.8 trillion balance sheet or the pace of that reduction.

Our base case expectation remains for four rate hikes this year, but we acknowledge risks are present in both directions. Ongoing strength in inflation could see rate hikes delivered at a swifter pace, while a moderation in growth, inflation and wage gains could allow for a more gradual stance. We are also mindful of an acceleration in the withdrawal of global liquidity as the balance sheet runoff gets underway.

Rick Rieder, chief investment officer of global fixed Income and head of global allocation investment team, BlackRock
What we heard from the Fed, or from Chair Powell, makes it clear that three to four policy rate hikes this year is within a reasonable estimate for Fed execution, along with the end of QE and some later (potentially summer) deliberate runoff of this excess liquidity. It is clear at this point that the Fed has inflation firmly in its sights, despite the still maturing nature of this economic recovery, but it has also very much kept the door open to adjust policy if the economy slows from here. Still, the implication is that we will hear significantly more detail about all this at the next (March) Fed meeting. So, the markets have been starting the drum roll, and we have started to warm-up the music for the next round of Fed actions, but the band will really hit the stage in March with a new set of instruments than what we have been used to over the prior couple of years.

Anna Stupnytska, global macro economist, Fidelity International
At the January meeting, the Fed took no policy action, in line with expectations. The Fed's main objective this month was to communicate its next steps for the tightening cycle that is being kicked off this year. The statement provided new guidance on the lift-off which "will soon be appropriate" and on the balance sheet, with asset purchases now expected to end "in early March".

Notably, the statement also included new references to inflation "well above two per cent" and a "strong labor market". Clearly, inflation is the Fed's prime concern right now, suggesting that the bar for changing the hawkish narrative in the near term is exceptionally high. This is also helped by overall financial conditions which, despite the recent sell-off in equity and bond markets, remain extremely easy. This should allow the Fed to hike at 25bp increments three to four times this year.

While we believe three to four rate hikes and some balance sheet runoff is achievable in 2022 (though of course the balance sheet devil is in the detail), we are more skeptical on the tightening pace in 2023-24 that is currently priced in by the markets. With the debt burden so much higher after the pandemic, real rates have to remain in the negative territory for a long period of time, for the debt trajectory to stabilize at sustainable levels. Indeed, we believe maintaining negative real rates is currently the implicit policy objective of all major central banks. In this respect, the Fed's policy action over the next few months is likely to be guided by real rates – a major shock resulting in positive real rates would likely lead to a more dovish stance. Ultimately, this tightening cycle is unlikely to be much steeper or longer-lasting than the last.

Charles Hepworth, investment director, GAM Investments
What we learnt was the Fed is still set to end the asset purchase facility by early March and will look to shrink their balance sheet at some undefined point in the future, after they have started hiking rates. They also noted that with inflation being now far from transient, the appropriateness of raising rates soon is imperative. All in all, there was not much in their statement to spook markets that hadn’t already been priced in – nor was it a walk-back of previous hawkish comments that would have otherwise threatened their credibility.

Ronald Temple, managing director, co-head of multi asset and head of US equity, Lazard Asset Management
The Fed needs to distinguish the signal from the noise. Some investors think the Fed is behind the curve. Others are fearful of the inevitable withdrawal of a tsunami of easy money. The reality is that growth is decelerating, inflation is near a peak, and unemployment may increase in the second half of 2022 as workers re-enter labor markets. Against that backdrop, the best option is to tighten policy marginally and retain flexibility, recognizing it is easier to reduce inflation caused by overheated demand, than to correct for excessive hawkishness.

Investec
Although there was no change in policy yesterday, there was a clear nod toward higher rates at the next meeting in March, and quantitative tightening to begin later this year. This is in line with our base case, which envisages a 25bp hike in the Federal funds target range of 0.25 to 0.50 per cent in March, and balance sheet runoff to commence from September. Our forecast also looks for two further hikes in 2022. We do acknowledge however, the potential for more aggressive tightening, or a larger step increase in the Federal funds target range in March, if the inflation outlook deteriorates further. Our next point of interest is the Employment Cost Index for Q4, a mix-adjusted indicator of wage growth, set to be released tomorrow (Friday 28 January). This measure is a clear indication of how entrenched inflation may currently be.

Richard Flynn, UK managing director, Charles Schwab
In December, the Fed announced that it would taper its bond-buying program at a faster rate in a bid to control inflationary pressures. Today's announcement represents continuity. Based on the recent indications, we expect to see the federal funds rate increased three times in the year ahead, perhaps starting as early as March.
 
However, the Fed may come under pressure from hawkish investors who are concerned that it could be doing more to keep inflation under control. Inflation had been relatively dormant for the past decade, but the US economy is now facing strains from higher prices and companies' inability to find skilled workers. The rate of inflation in the US is persistently above the Fed’s two per cent target and December's CPI Index recorded the largest annual gain in inflation since 1982.
 
The challenge for the Fed is to try to slow inflation without tipping the economy into a recessionary downturn. The unfortunate reality is that the path of inflation, and the economy at large continues to be driven by the virus, and with Omicron rapidly spreading throughout the world, global supply chains – in their already fragile state – are at risk of persistent bottleneck pressures.