Federal Reserve Liftoff of 25 bps Likely Next Week, Tapering Has Ended

FS Insight Team

The Fed got no favors this week as the war in Ukraine continued to rage with ominous implications for inflation. Next week’s March meeting will mark the end of the post-pandemic monetary era and the beginning of the biggest challenge for the world’s most powerful central bank Paul Volcker was chairman. Indeed some, similarities between that time and now are becoming more poignant as sanctions have the potential to create an intense supply shock.

Tapering of asset purchases has also concluded. For the first time since the pandemic response began, the Fed is no longer purchasing securities on the open market. There will be quite a bit of attention paid to the Powell’s statement and questions with regard to the balance sheet. Ben Bernanke astutely pointed out in a paper from 2004 that the Fed cannot simultaneously tackle the recessionary and inflationary effects of commodities spikes at the same time. If rates are lowered it risks adding inflationary pressure and if they are raised enough to offset inflation they may exacerbate an economic slowdown.

Similar to the 1973-1974 oil shock and the subsequent period of stagflation, loose fiscal policy from the Vietnam War, as opposed to a pandemic made the situation harder for the Fed. Crop failures that year also contributed to the perfect storm as former Fed Chairman Arthur Burns testified. The Fed will have to carefully weigh its mandates of price stability, employment and financial stability. Luckily, in the United States at least financial contagion isn’t a major issue for now. This could always change in a worsening situation.

The changing economic forecasts since Russia’s invasion have been tilting in the direction of more inflation and less growth. In early February markets were placing the odds of a 50-bps hike at nearly 90%.  Our Head of Research Tom Lee and Head of Data Science Ken Xuan pointed this out before the fact, that outcomes Fed Futures implied by Fed Futures rarely come to fruition. Markets still price an average of 6 bps hikes or so, but we believe the great uncertainty associated with Ukraine makes this even less reliable than normal.

Fed officials have been very unified in previous weeks about the need to effectively counter inflation. The unique dynamics from the pandemic and demand patterns that may never return were largely responsible for a lot of the botte necks in supply chain. The Fed comments at the meeting next week will likely provide lower expectations for growth and higher ones for inflation. The War in Ukraine will affect commodity prices directly, but as an increasingly desperate flight to safety from more affected parts of the world and away from emerging markets occur, it may also raise the demand for safe and hard assets like US Real Estate. The tight housing market is already showing a lot of strength.

Let’s remember that the elevated demand for US assets and a global savings glut had profound consequences in the run-up to the Global Financial Crisis. Sovereign wealth funds of autocracies are probably looking at a lot of assets they held in reserve differently after the US and allies sanctioned Russia’s central bank directly. Much of the war chest of reserves Putin had hoped would help him weather sanctions will no longer be accessible to him. However, other leaders will take note and we will monitor the implications of this going forward.

The next Fed meeting will be one of the most anticipated in recent history. Powell will be heavily scrutinized for any hints to how they will adapt to the evolving situation in Ukraine. The tapering of asset purchases has concluded. The benchmark yield on the 10-Year Yield was 1.927%

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