Market and omicron risks pose a new challenge for the Fed’s policy turn

After drawing up a clear battle plan against inflation, the authorities of the Federal Reserve (Fed) from U.S now they must deal with new signs that the COVID-19 is slowing the economy, as well as with markets poised to tighten financial conditions faster than the central bank forecasts.

The combination of economic data pushing in one direction and investors in another could make next week’s Fed meeting unexpectedly complex, as policymakers try to balance uncertainty over the health crisis with markets reeling. quickly adjust around projections of a more aggressive stance on inflation.

The central bank has been clear that interest rates will rise this year – at its December meeting, all officials expected at least one rate hike and half expected three – and that it would also reduce its $9tn asset size. dollars as a second means to tighten monetary policy.

In recent weeks, there has been a perception that the Fed could use its meeting next week to refine the message of a possible initial interest rate hike in March, along with a balance sheet reduction for later in the year. anus. But the scenario seems to be changing and the risks are different.

Recent data on retail spending was disappointing, real-time measures of economic activity have declined and hiring may have fallen, in response to the massive wave of coronavirus infections fueled by the omicron variant.

The daily pace of infections may now be slowing, but other risks to the recovery remain, including a drop in federal government spending that has helped support disposable income for families during the pandemic.

Data from payroll provider UKG showed shift work was down 5% in the week ending January 16 compared to the previous week, a sign that coronavirus infections may produce another disappointing jobs report in January. after growing just 199,000 positions in December.

“The recovery weakened a bit more” earlier in the year, with employment indicators below where they were before the holidays, Oxford Economics economist Oren Klachkin said, with the omicron outbreak “dragging employment down”. The company’s recovery index hit 100 in October before falling in recent weeks.

Fed officials are hopeful that the pandemic’s drag on the economy will ease soon, but they will have to live with doubts until it becomes clear that the omicron variant will decline in the United States as fast as it did in South Africa and as it seems be happening in other parts of the world.

The Fed is treating signs of slow growth “as temporary, due entirely to omicron-related disruptions,” Natixis chief economist Joseph Lavorgna wrote.

“This would be a mistake. There will be a historic tightening of fiscal conditions this year. Raising interest rates during a growth slowdown raises risks” that Fed policy will further weaken the economy and perhaps trigger a recession.

The buzz of the markets

At next week’s meeting, the challenge is to acknowledge the economic risks of the virus without diminishing the commitment to fight inflation or, conversely, being so concerned about prices as to lead investors to expect even tighter policies. .

Investors, so far, have accepted the Fed’s consensus on rate hikes and followed it.

Interest rate futures markets reflect strong odds of up to five rate hikes this year of a quarter percentage point each, and real-world borrowing costs for consumers looking to buy a home, businesses looking to raise capital and even the US government have skyrocketed.

As a result, US stocks have fallen sharply since the beginning of the year as investors fear higher rates will hit tech stocks and growth-linked paper.

The markets are abuzz with rumors that the central bank could make history with its first half-point rate hike in over 20 years and abuzz with speculation that it will start depleting its balance sheet faster than anticipated and will tighten credit conditions another notch.

Even Fed officials most concerned about inflation know there are limits to how quickly the central bank can move without risking a backlash in financial markets, which could slow spending and hiring more than the desired.

Asked about the possibility of the Fed raising rates by half a percentage point in March as a kind of shock treatment against inflation, Fed Governor Chris Waller said there was no mood for that.

“We haven’t prepared the markets for anything this dramatic,” Waller told Bloomberg TV last week.

But the Fed finds itself in a situation it hasn’t faced for a long time, if ever, as it tries to bring down inflation in an environment where global supply chains may be protracted out of whack. , fueling higher prices through a channel beyond the influence of the central bank.