The decisions of the FOMC meeting, which will be embellished with updated economic projections and Powell's press release, will be in our hands by tomorrow. Despite the uncertainties caused by the Ukraine invasion, the Fed is expected to initiate the cycle of rate hikes, which will start with a 25 basis point increase at its March meeting. While this was signaled in the Congress presentation made by Powell, there will be details that we wonder about the plan that goes to the terminal rate and balance sheet reduction rather than the monthly interest decision taken by the markets to the base scenario side. In this light, the Fed's updated dot chart and views on the balance sheet will be closely scrutinized by the market for future policy clues.
During the Russian invasion of Ukraine, the path forward became somewhat uncertain due to geopolitical and macroeconomic concerns. While a long-term supply chain crisis triggers inflation, the energy and input gap that will occur with the new dynamics will mean both additional inflation and a slowdown in the economic growth cycle. Supply chain bottlenecks worsen again, input costs and housing prices continue to rise. At this stage, in any case, policymakers' response to the Ukraine war remains a key element of uncertainty. The coefficient of growth, impact from sanctions and war, of course, varies by region and country, and because of its less energy dependence, the USA is in a position to rely more on its own indicators. After all, the economy seemed strong enough before the Russian invasion of Ukraine. Plus, inflation has risks for demand growth, as with inflation soaring, households may decide to rethink their budgets and cut discretionary spending. The risk of looking at past indicators from the recovery period, or will it break with the Russian crisis?
Although some supply chain disruptions started to ease in February, we observed in the current inflation data that rising energy and personnel costs drove prices up at a rate that approached the previous record levels. Supply chains are being interrupted again, adding to downside growth risks, and at the same time exacerbating inflationary pressures. We already know that rising energy prices will shape inflation. Oil prices, which rose to the level of 130 dollars when the war with Russia began, and are now around 110 dollars, constitute the main uncertainty. Accordingly, in order to understand how the Fed will respond to the oil price shock, it will be necessary to read the updates it will make in its forward economic projection summary.
The timing for the balance sheet normalization will likely not be specified, but the outline of the plan will emerge. $50 billion in the first round ($30 billion for the UST and $20 billion for the MBS) could be advanced to $100 billion per month ($60 billion for the UST, $40 billion for the MBS) three months later. For the second round of downsizing planning, Powell will look to the conditions of the war.
Fed December 2021 dot graph interest rate projections… Source: Federal Reserve, Bloomberg
The main lines of economic projections will be based on higher inflation and slower growth. It is possible that the 2.2% - 3% PCE inflation band, which is the central tendency for 2022, will be revised upwards, and an inflation above the 2% band is foreseen until 2024 in terms of the average target. How oil prices are predicted is decisive for 2022 projections. The extent to which they adhere to the rhetoric that inflation will be temporary will also guide forecasts for 2023-24 and beyond. If the Fed projects expectations such as the end of the Russia-Ukraine crisis and the normalization of supply chains to a longer term in terms of inflation, this will be perceived as relatively dovish. And of course, the dot chart changes accordingly: Fed members revealed 3 rate hikes this year in their December economic projections summary, but we reflect that this will change. The fact that swap traders have moved back into 7 interest-rate positions complicates things, so we'll be comparing the dot chart with this pricing in futures funds. The terminal rate is likely to remain at 2.5%.
We expect a cycle that will start with 25 basis points and continue with the traditional band for rate hikes. We do not expect them to increase the cycle to 50 basis points in order not to trigger the risk of a hard landing and recession too much, but this possibility was seriously considered before the start of the war with Russia and it was the move of the Fed under normal circumstances. Now, in order to position the tightening phenomenon somewhere in the middle position, we expect the movement in interest rates to be more moderate, but the movement towards the terminal rate has also started.
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