Shaky Recovery After Fed Hints at Interest Rate Steps

Interest Rate Steps

Perhaps the most exciting market event recently was last week’s Federal Reserve meeting. In the run-up, the markets had already buckled. Did the outlook improve after the meeting? First of all, the Fed did nothing unexpected. It left the key interest rate unchanged and, as expected, hinted at an “imminent” rate hike.

Tight Monetary Policy: Interest Rate Steps Up, Balance Sheet Down

This will happen as soon as the bond purchases have ended. This in turn should be at the beginning of March. Until then, government bonds and mortgage securities are still to be purchased for a total of at least $30 billion.

Even more important for the market is likely to be the planned reduction in the central bank’s balance sheet total. This is a “real” monetary tightening, as it will gradually withdraw liquidity from the market. This is to begin after the start of rate hikes. The intention is to do so in a predictable manner. But also in line with the Fed’s goals of maximum employment and price stability.

That is, as soon as the economy slumps, this process is expected to be halted again. In the past, such an approach has not always worked optimally. It’s led to turbulence in the markets, most recently in late 2018.

Monetary Policy Wants to Remain Predictable

At the press conference, Fed Chairman Powell said that no decision had yet been made on the size of the interest rate steps. The market apparently interpreted this as a possibility of a large rate hike of 50 basis points in March. However, I think that is unlikely.

In addition, the central bank chief said that in reducing the balance sheet total, it would be possible to proceed earlier and possibly faster than last time. The balance sheet total will be reduced “substantially” and this will take some time. The reduction of the balance sheet total will proceed predictably and could possibly start later this year. He said that total assets would be discussed again in March and also at the following meeting.

This means that the real tightening is coming, possibly also in large steps, but not as soon as feared. The central bank apparently wants to prepare the market for the event first, so that there is no turbulence.

The Economy Should Not Be Stalled Either

The Fed’s monetary policy will adapt to the economic environment, he said. So Powell has learned from his mistake in 2018, when he wanted to run tightening on “autopilot,” sending markets down hard at times.

Powell also said no decisions have been made about the future path of monetary policy and will be guided by economic data and the environment. He said it was not possible to predict the monetary policy path. The market has a clear opinion on this…

Four Interest Rate Steps Are Priced Into The Markets

For the next Fed meeting in March, the probability of a small rate hike of 25 basis points is 91.6%, for May it is 51.2%, for June 44.3% and for July 44.7%. This does not mean that there are likely to be four rate hikes between now and July. The rate hike plan may also be suspended in the meantime.

According to the market, there is then a very high probability of a pause for September, before there is again no decision for November. At the end of the year (December), the majority of investors expect the Fed Funds Rate to be at 1.0% to 1.25%, which would ultimately be four rate hikes in small steps each.

I think the problem isn’t the interest rate steps, but the pace and size of the reduction in the Fed balance sheet. In the financial markets, the U.S. dollar rallied sharply after the statements, and U.S. government bond yields also rose. Stocks, cryptocurrencies and gold went slightly down again after initially significant jumps.

Dr. Gregor Bauer
Dr. Gregor Bauer
Dr. Gregor Bauer credits his trading success to combining fundamental aspects of a trade with expert technical analysis. A Certified Financial Technician from the International Federation of Technical Analysts (IFTA), he’s rated as one of Germany’s top 300 economic experts.
Dr. Gregor Bauer
Dr. Gregor Bauer
Dr. Gregor Bauer credits his trading success to combining fundamental aspects of a trade with expert technical analysis. A Certified Financial Technician from the International Federation of Technical Analysts (IFTA), he’s rated as one of Germany’s top 300 economic experts.

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