Federal Reserve Leaves Policy Unchanged, Telegraphs March Hike

Karthik Sankaran - Senior Market Strategist

The Federal Reserve held rates unchanged today but cleared the deck for a rate hike at its March 15-16 meeting. Policymakers said, “With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate. The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March.” A separate statement setting out “Principles for Reducing the Size of the Federal Reserve's Balance Sheet” suggested that the central bank’s holdings would be reduced “over time in a predictable manner”, “primarily by adjusting the amounts reinvested of principle payments.”

Though there was no explicit commitment to a rate path, the moderate tone of the statement was largely in line with market expectations for quarterly 25 basis point moves, and an eventual shift toward a gradual runoff in the balance sheet.

Comfort on appropriate stance: The statement highlighted inflationary pressures but located them to a good degree in “supply and demand imbalances related to the pandemic and the reopening of the economy”. In addition, policymakers said, “Progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation.” In focusing on the health of the job market, and the likelihood that the extraordinary factors that had pushed inflation to 40-year highs would abate soon, the message reflected Fed comfort that an earlier rate liftoff than projected at its December meeting and a gradual path of rate increases would be consistent with both its employment and inflation targets.

Economic backdrop and risks: The most recent data release of November 2021 showed a year-on-year increase of 4.7 percent in the Fed’s preferred inflation measure (personal consumption expenditures excluding food and energy). Even if the Fed is correct in thinking that intermediate price pressures are abating on many fronts, markets will remain on edge if an inflection point in consumer inflation data is not visible soon. Any data that ratifies fears that the Fed’s measured approach to hiking is too little - or too late - could push short-term interest rate markets to price more aggressive rate increases in 2022, hitting equities and commodities and boosting the dollar more broadly.

Muted response to be tested by data: The immediate market response was relatively tame, with equities maintaining their gains earlier in the day and currency markets largely stable. However, a slew of data on US growth and inflation due in the coming days will command market attention as participants assess the appropriateness of the Fed’s policy stance.