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First strategy, next tactic.

After belatedly admitting that inflation is proving to be more intransigent than transitory, the Federal Reserve, at its eagerly awaited policy meeting which ends on Wednesday, is expected to indicate how it will adjust its policy to contain rising prices.

This will likely consist of cutting back on its asset purchases more quickly, allowing for a faster take-off from its target range of federal funds than it previously reported. Although widely anticipated, this change is seen as leading to widely divergent results by analysts and seasoned investors.

Some consider the Fed’s shift to a less accommodative stance inadequate and long overdue, given the massive stimulus measures provided since March 2020 as the economy and financial markets have entered a virtual free fall in the wake of the Covid-19 crisis.

Since then, however, the economy and markets have recovered, with inventories at new highs and the labor market plagued by a shortage of workers rather than jobs. Meanwhile, inflation is at its highest in 39 years after hitting an annualized rate of 6.8% in November, while house prices are skyrocketing faster than they did during the famous war bubble.

Others, however, view the Fed’s change as overly brutal. As price pressures are expected to ease in 2022, they see the central bank blundering by starting to raise interest rates just as growth slows.

There is less disagreement over the more immediate question of what the Federal Open Market Committee will decide next week. Fed watchers of all stripes are looking for the policymaking panel to cut its bond purchases faster.

The FOMC announced in early November that it would cut its monthly purchases of treasury and agency securities to $ 120 billion by $ 15 billion. The FOMC is expected to double that pace, slashing purchases by perhaps $ 30 billion per month. Once the Fed completes its purchases, the lift-off of the fed funds rate from the current range of 0% to 0.25% at ground level can begin.

Economists have pushed ahead their planned timeline for rate hikes since central bank officials changed their tone, including Jerome Powell, addressing Congress in late November (and after President Joe Biden appointed him for a second term at the head of the Fed).

The federal funds futures market is anticipating the first boost for June (although a takeoff in May was a bit better bet than even silver on Thursday), according to the CME FedWatch website. A second increase is scheduled for September and a third has a one in 10 chance in December.

What the markets will focus on is what the FOMC itself is forecasting in its “dot plot” projections on Wednesday. Its last projection, in September, involved just one rate hike in 2022, with fed funds at 0.30% at the end of the year and 1.00% at the end of 2023.

The new dot plot will undoubtedly show higher inflation and lower unemployment, which justifies abandoning the current extreme accommodation. Despite the increase in the non-farm payroll for November to 210,000, all other labor market indicators show robust health.

The unemployment rate, down to 4.2% last month, could reach 3% or less in 2022, according to projections by Evercore ISI, based on trends in the unemployment rate, job vacancies and trends. departures. And the Fed should note the insight offered by Barron Lisa Beilfuss that the “long Covid” prevents a recovery in the activity rate. This would imply that the central bank’s goal of maximum employment is practically achieved.

Other Fed watchers, including Steve Blitz at TS Lombard, believe the first rate hike could come as early as March. He sees the central bank tightening as (belatedly) aimed at preventing a wage-price spiral from taking hold, rather than countering the much-heralded supply chain disruptions.

That would involve four quarter-percentage point rate hikes in 2022, and it would likely hit markets, especially stocks, first, Blitz adds. With Powell & Co. likely to protect the stock market, all of those fed funds rate hikes are unlikely if stocks are beaten.

Scott Minerd, global director of investments at Guggenheim Investments, says the rate hikes would be a major policy mistake on the part of the Fed. Property prices are expected to ease and may head for deflation next year, he adds.

This is the message of the sharp flattening of the yield curve, with long-term Treasury yields falling, even as they rise sharply in the short term pending Fed hikes. The risk, according to Minerd, is that the United States will experience a recession in 2023.


BNP Paribas

economists agree that the yield curve behaves as if the Fed risks a policy error by tightening too quickly. But he retorts that, alongside the current robust economic indicators, the Fed’s own plan was to be “late” in allowing inflation to rise and employment to peak.

But even if the Fed were to steadily increase the fed funds rate sevenfold by the end of 2023, to 1.75% -2%, as BNP Paribas expects, its policy rate would remain negative in real terms (assuming that the central bank’s preferred measure of inflation, the personal consumption deflator, comes down to 2.2%, according to the latest dot plot, from 5% in October).

Finally, Powell also remembers 2018, when the central bank raised the fed funds rate to 2.50%, above zero in real terms, while reducing its balance sheet. The result was a bear-like experiment, with the


S&P 500

decline stopping just below 20% in the fourth quarter. Based on this episode, it is more likely that the monetary authorities are going the other way, with inflation ultimately far from transient.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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