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New Year, New Fed, New Economy?

U.S. News & World Report logo U.S. News & World Report 1/24/2022 Tim Smart
FILE - Federal Reserve Chairman Jerome Powell speaks to lawmakers during a House Committee on Financial Services hearing on Capitol Hill in Washington, Dec. 1, 2021. With inflation surging, unemployment falling and wages rising, some economists are warning that the Federal Reserve may have waited too long to reverse its ultra-low-rate policies — a delay that could put the economy at heightened risk. (AP Photo/Amanda Andrade-Rhoades) © (Amanda Andrade-Rhoades/AP) FILE - Federal Reserve Chairman Jerome Powell speaks to lawmakers during a House Committee on Financial Services hearing on Capitol Hill in Washington, Dec. 1, 2021. With inflation surging, unemployment falling and wages rising, some economists are warning that the Federal Reserve may have waited too long to reverse its ultra-low-rate policies — a delay that could put the economy at heightened risk. (AP Photo/Amanda Andrade-Rhoades)

Be careful what you wish for.

That might be the advice for economists, Wall Street analysts and politicians who have argued for several months that the Federal Reserve Board needed to ditch its accommodative monetary policy and use the blunt edge of interest rates to cool off a hot economy and the worst inflation in 40 years.

Well, this week, the Fed will provide some indication of just how it plans to do that.

On Wednesday, following a two-day meeting, Fed Chairman Jerome Powell will update the central bank’s plans for the economy, with expectations he will signal the beginning of rate hikes starting in March. He may decide to omit the actual details while issuing a statement that observers will parse to draw their own conclusions as to how the Fed will proceed.

But, in any case, the handwriting is on the wall for a dramatic shift in monetary policy away from an era of near-zero interest rates and the start of a tightening cycle that could last a few years.

The Fed has a handful of tools it can use to reverse policy. It has already begun paring back its purchases of Treasuries and mortgage-backed securities. It can raise interest rates. And it can begin to reduce its nearly $9 trillion in holdings of securities by not re-upping its bonds as they mature.

“As we move through this year … if things develop as expected, we’ll be normalizing policy, meaning we’re going to end our asset purchases in March, meaning we’ll be raising rates over the course of the year,” Powell told members of the Senate Banking Committee earlier this month during confirmation hearings for a second term as chairman. “At some point perhaps later this year we will start to allow the balance sheet to run off, and that’s just the road to normalizing policy.”

With Powell’s pivot, “the bond market has gone from pricing in one 2022 rate hike just a few months ago to now pricing in three to four,” says Jeff Buchbinder, equity strategist for LPL Financial. “That’s one of the more dramatic hawkish shifts by the Fed in a short period of time that we’ve ever seen.”

Dan North, senior economist at Euler Hermes, says “the worst thing any Fed chair can do is surprise the economy and the markets,” yet he adds, “I think the Fed is way, way behind.”

North sees the extreme tightness in the labor market as a worry for the Fed and the economy, with America growing older, declining birth rates and accelerated retirements – factors that are likely to continue well beyond the pandemic – something he terms a “fatal demographic.”

An economy needs a continual resupply of young, productive labor force to keep growing. Yet, he says, “you have a greater cohort of people who are getting older, sicker and being kept alive longer than was planned for.”

What’s making the Fed’s about-turn even more dicey is that as it begins to tighten, other forces are conspiring to potentially add to an economic slowdown from the heady pace of 2021: the diminishing impact of fiscal stimulus that Congress approved to fight the coronavirus pandemic in 2020 and 2021, the failure of Joe Biden’s Build Back Better plan and even the recent sell-off of the market-leading tech stocks.

Ahead of the meeting, stocks fell sharply early Monday with the Dow Jones Industrial Average down nearly 800 points by midday and the S&P 500 falling into correction territory.

The market’s jitters “are already tightening the economy,” says David Page, head of macro research at AXA Investment Management, adding the Fed shift augurs “a tightening cycle that will play out over several years.”


Video: Fed rate hikes: It's still ‘going to be a risk-on market,’ WealthWise Financial CEO says (Yahoo! Finance)

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It’s also a move that has huge political repercussions. While the Fed does a good job of staying above the political fray, if it fails to corral inflation or drives the economy into recession, Biden will likely pay a heavy cost. Just ask Jimmy Carter in the 1970s or George H.W. Bush in the 1990s, both of whom fell victim to perceptions they failed to respond to the economic worries of voters.

To counter negative polling on the economy, top Biden administration officials have taken to blaming inflation on the pandemic and global disruptions to the economy. At the same time, they are touting such achievements as passage of the American Rescue Plan that put money into the pockets of Americans, rising wages and reductions in household poverty.

Treasury Secretary Janet Yellen gave a full-throated endorsement of the administration’s economic policy on Friday during a virtual version of the annual Davos gathering of the rich and powerful hosted by the World Economic Forum.

“By most traditional metrics, the pace of our current recovery has exceeded even the most optimistic expectations,” Yellen said. “That’s due in large part to rapid vaccine deployment and the robust support to families, businesses, and state and local governments provided by the American Rescue Plan. This is the kind of recovery that President Biden set out to deliver when he took office last year.”

Yellen ticked off the numbers: Gross Domestic Product expected to grow at 5.3 percent in 2021, well above expectations earlier in the year, over 6 million jobs added last year and the unemployment back below 4%.

But Americans aren’t buying it. A Gallup poll released last week ahead of the one-year anniversary of Biden’s inauguration found his overall approval stands at 40%, the lowest of his presidency, though there were wide divergences by political party.

While the Fed meeting dominates the economic news of the week, it is also earnings season and there are some big names on tap, including tech giants Apple and Microsoft. With tech stocks already bleeding, any slip or suggestion of slowing profit growth will likely lead to a sell-off.

There will also be a rich trove of economic data, including readings on consumer confidence, fourth-quarter GDP and personal income, spending and inflation.

Stocks actually have a history of doing well during the early stages of interest rate hikes. But once the dust has settled, the picture tends to darken and if inflation sticks then it usually spells trouble for the markets. That has some analysts worried, as the economy is now confronting wage inflation, something that is harder to tame than rising prices for goods and services.

Preston Caldwell, head of economics for Morningstar Equity Research, sees glimmers of hope in the inflation scenario with much of the rise in prices concentrated in areas that could see a reversal once supply chain bottlenecks loosen up.

“Autos, other durables, energy, all those variables are going to unwind in the next few years,” Caldwell says. As for omicron, “we think the impact will be fairly limited.

Long-time Fed watcher Hugh Johnson says that if the Fed raises rates three or four times this year and 2023, then the S&P 500 will deliver positive returns, though below that of 2021.

“To a great extent the decline in the stock market has reflected/discounted the impact,” Johnson wrote on Monday. “There are of course a number of additional issues (geopolitical tensions between Russia and the Ukraine, supply chain disruptions, US fiscal policy, China slowdown) that are important and are being integrated into financial asset prices.”

“There may be more declines ahead,” Johnson added. “Regardless, we remain confident that the declines are not signaling the end of the current stock market-economic-interest rate cycle.”

Still, there are dissenting opinions.

Natixis CIB Managing Director Joe LaVorgna worries that the Fed is tightening into an economy already slowing and facing the fiscal drag from reduced stimulus and rising market interest rates. He notes that “the fiscal impulse” – the change in the ratio of the federal budget deficit to gross domestic product – is set to rise from a negative 1.5% of GDP in 2021 to negative 8.7% in 2022, a sharp brake on growth.

“This is the biggest relative and absolute change in the post-WWII era,” LaVorgna points out.

“For the record, the next largest negative fiscal impulse was -3.1% in 1969, he notes, adding that the figure helped tip the economy into recession that year. “Today’s drag is estimated to be nearly three times as large. Fed policymakers have been warned.”

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