Federal Reserve policymakers are facing a delicate balancing act as they start their two-day monetary policy meeting on Tuesday — on one hand the economy looks strong as demand isn't retreating and the unemployment rate stays slow, but inflation, poised to push even higher with surging oil prices triggered by the Ukraine war, reduces the central bankers' chances of successfully pulling off a soft landing. And the increased uncertainty stokes fears about a "stagflation" scenario, where GDP growth stalls but prices march higher.
"The Fed is currently navigating in an economic and financial environment that is more complicated than any other in recent history," Luis Alvarado, investment strategy analyst at Wells Fargo Investment Institute said in a recent note.
Currently, markets are pricing in seven rate hikes this year, which would average a 25 basis point hike for each meeting remaining in 2022. Earlier this month, Fed Chair Jerome Powell said a 50-bp hike at a later meeting or meetings is an option. Keep in mind that Powell recently emphasized that the policymakers aren't on "auto-pilot" and need to be nimble in assessing incoming data.
After the January Federal Open Market Committee, the Fed officials indicated they'll start raising rates in March, two years after they slashed their key interest rate to near zero in response to the COVID emergency. Soon after the January meeting, traders saw an increasing probability that the Fed would boost the federal funds rate target range by 50 basis points, instead of the typical 25 bps hike. That changed when Russia moved into Ukraine. The probability of a 50 bps increase has faded to 1.7% vs. 41.1% a month ago, according to the CME FedWatch Tool.
Even in good times, a soft landing can be tricky. Wait too long to raise rates and inflation can surge, suppressing economic activity. Act too early and the higher rates can limit growth leaving workers on the sidelines.
"The Fed has little choice but to withdraw financial accommodation as anticipated prior to the Russian invasion of Ukraine," Tim Duy, chief U.S. economist at SGH Macro Advisors. "The fresh supply shock only aggravates the inflation picture."
Paul Gray, managing partner of IronHold Capital, said it's likely the Fed will raise rates. "With inflation surging, there is really no alternative to the Fed raising rates, which has the possibility of sparking a surge of selling in the equity markets," he said in a note to investors.
"The amount by which they rise will make or break the overall markets, but it will be hard to stop the surging inflation and please equity investors at the same time," Gray added.
"We believe the Fed's hand has been forced to act swiftly and they will attempt to raise rates several times in 2022," Wells Fargo's Alvarado said. "However, after some hikes, the Fed could take a more cautious approach."
Due to global economic uncertainties, Powell and the Fed board aren't likely to be too aggressive with this first rate hike, said SA contributor John M. Mason. At the same time, though, inflation may push central bankers "to do more than they would really like to do," he added.
Expect Powell to provide more guidance on the central bankers' plan for shrinking the Fed's ~$9T balance sheet. During his testimony to Congress earlier this month, he said he expected it would take about three years to get the Fed's balance sheet where it needs to be. The policymakers aren't expected to discuss a plan at this meeting but not finalize it.
Goldman Sachs strategists expect the FOMC to publish its balance sheet plan at the May meeting and start the balance sheet reduction at the June meeting. "We continue to expect the FOMC to permit passive runoff at $60B per month for Treasury securities and $40B per month for mortgage-backed securities and to ultimately shrink the balance sheet from just under $9T today to just over $6T in 2025," the Goldman note said.
Duy doesn't expect Powell to soften his hawkish tone of the past couple post-FOMC press conferences. "Importantly, he won’t be inclined to send any signals that trigger market participants to back down from current pricing and if anything, probably wants more rate hikes priced in for 2023," Duy said in a note to clients.
Also see: Want to bet on the Fed? Here are ETFs to watch ahead of the FOMC rate decision