Yesterday, January 26, the Fed Open Market Committee (FOMC) released its first monetary policy announcement of the year, keeping the interest rate unchanged, in line with market expectations. .
However, the market’s attention was focused on the content of the statement and the press conference, seeking greater clarity on the critical path of the monetary policy normalization process.
Specifically, the market was very attentive to the confirmation of the first increase in the funding rate for the March meeting and was looking for clues about the path of increases for the rest of the year.
Likewise, the specialists were very attentive to possible signals about how and when the process of withdrawing liquidity and reducing the Fed’s balance sheet will begin. As we have emphasized in this space, this last point is the most relevant for the markets after The Fed will increase the size of its balance sheet from 4 to 9 trillion dollars from March 2020 to date.
The Fed statement presented some important changes compared to the December meeting.
The main one was the confirmation that it considers it appropriate to raise the funding rate in the short term. The central argument behind this statement is based on the explicit acknowledgment that the objective of bringing the labor market to full employment has been met and that inflation is above the Fed’s target.
Likewise, the Fed’s message makes it clear that inflation levels have been higher and more persistent than expected just a few months ago. The statement, like the December one, set aside mentions of the transitory nature of inflation and made an explicit acknowledgment that the high levels of inflation are due to imbalances between supply and demand related to the economic reopening and the aftermath of the pandemic.
In his intervention with the press, the chairman of the Fed, Jay Powell, mentioned that there is a risk that inflation will not drop to its pre-pandemic level and that the rise in prices could even accelerate.
In this context, the Fed removed from its statement the reference to the need to continue taking measures to support the economy to mitigate the extraordinary effects of the pandemic in order to prioritize controlling inflation.
Regarding the future trajectory of the funding rate, there were no changes with respect to the signal sent in December that anticipates three increases for this 2022. However, the market has already discounted four increases and some observers think that it could be more.
On the critical issue of shrinking its balance sheet, the Fed accompanied its press release with a separate one-page document setting out the principles of such a process. Although the document does not set specific dates or amounts, it does establish that the balance reduction plan will not begin until the process of raising the funding rate has begun.
This implies that the Fed could start withdrawing liquidity as soon as March if the inflationary trajectory continues to worsen. However, the Fed was very careful to emphasize that the process of withdrawing liquidity will be done in a careful and predictable manner, and that before starting to sell assets it will make gradual adjustments in the amount of reinvestment of amortizations of financial instruments that today They are in your balance.
The announcement was not well received by the markets, which erased their intraday gains and closed in negative territory after the announcement.
As we have already discussed in this space, after years of near-infinite liquidity, the main concern of the markets is how aggressive the Fed’s balance sheet reduction process will be in an environment of persistent inflation. The Fed has the difficult task of balancing the withdrawal of liquidity to fight inflation without causing a disorderly adjustment in the markets.
Socio Director de EP Capital, S.C.
Joaquín López-Dóriga Ostolaza is Managing Partner of EP Capital, SC, a consultancy specialized in mergers and acquisitions founded in 2009.
He is a graduate of the Bachelor of Economics from the Universidad Iberoamericana, where he graduated with honors and the highest average of his generation. He has a Master’s degree in Economics from the London School of Economics, where he was distinguished with the British Council Chevening Scholarship Award.