As we approach the last Federal Open Market Committee meeting of 2021, the big question is what will happen next with the Fed and the markets.
In a word: change. The committee is fretting about the pressure of unrelenting inflation on the economy. The supply chain remains clogged, causing product shortages amid strong demand and sharp increases in labor costs. All of these and more impact consumer and producer prices, causing the former to rise to its highest level in nearly 40 years (the Consumer Price Index is up 6.8% year over year).
Unfortunately, the markets don’t like change – but more on that in a minute. First:
What can the Fed do about rising prices?
The Fed has one permanent instrument and one temporary tool. The temporary tool is the easiest one to implement, and it’s already been announced: Taper the emergency bond buying program. The bond-buying will probably end by the close of Q2 in 2022.
The permanent tool is a bit trickier, and this is what’s bothering the markets. The tool is rate hikes, and the markets want to know when they’ll happen.
The rate hike dance between the Fed and the markets
Market are trying to figure out if the Fed will hike interest rates two or three times in 2022, and how many more will come after that. Throughout history, markets have not taken kindly to a tighter monetary policy.
Traders need to remember how we got here. The global pandemic was a potential economic disaster. Fortunately, the Fed put a blanket over a potential fire by lowering interest rates to zero. Now that blanket needs to be removed. But they won’t do it so quickly that the markets will be shocked, but it must also be balanced against risks to the economy. Right now, the biggest risks are tilted towards higher inflation.
Fed Chair Jerome Powell will give a press conference on Wednesday and is expected to explain their future actions (to a certain extent). Economic projections are likely to be all over the map from the committee, hence rising uncertainty over policy decisions. That uncertainty may stoke a bit of fear in the markets.
The dance between the Fed and the markets continues….
