Monetary policy is often seen as a boring, highly technical thing—yet monetary policy has massive implications for capital markets and for the lives of individuals in every country on Earth. Understanding the Federal Reserve’s moves not only gets you a big edge in the markets, but it also helps you understand how history is unfolding.
The Fed’s most recent open market committee statement (the “FOMC” that meets monthly) is a particularly telling example of this, but to understand what is going on involves a bit of a historical perspective and a lot of technical knowledge. So let’s dig in and see what Jerome Powell and his fellow chairs are telling the markets.
The statement itself is relatively short, and it doesn’t contain much that would surprise anyone. Statements like “The sectors most adversely affected by the pandemic have improved in recent months but are being affected by the recent sharp rise in COVID-19 cases” aren’t exactly groundbreaking, nor is it really amazing insight to say the “path of the economy continues to depend on the course of the virus”. The Fed is famous for making statements that are extremely obvious when they hold conviction and extremely vague or technical when they involve uncertainty.
This in itself is an important clue often used by Fed watchers to understand what they are doing: the clearer the language, the more confident the Fed is and the more likely it is going to take an action. In this case, stating that the pandemic is a major determinant in the economy means that the Fed is going to respond to the virus instead of proactively trying to influence the economy too much. This is a very big statement in the context of recent weeks, where the markets have panicked about aggressive rate hikes. The Fed is effectively saying, “we will be raising interest rates, but we aren’t going to be too aggressive if COVID-19 continues to ravage the economy or things take a turn for the worst because of the pandemic.”
In the next paragraph, the Fed says that it is likely to raise interest rates “soon”: “the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.” Here there’s more vagueness—what does “soon” mean? Next month? The month after? Most Fed watchers are pointing to March as the first possible month for a hike to the target Fed funds rate, largely because of what follows in the same paragraph.
“The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March.” This is an important statement; instead of the vague “soon”, we have gotten back to definitive and objective statements: the Fed will end its QE program in March after reducing its purchasing activity now (numbers of how much purchases will be made in February follow this statement). We are given a very clear timeline and are told explicitly what to expect from the Fed over the next two months: again, this kind of precision and clarity is unusual, and it exists precisely to tell the market exactly what is going to happen with QE. Such bluntness is rare for the Fed, but they are essentially telling the markets that this is absolutely going to happen no matter what, and the markets need to be prepared for this.
Of course, the markets already are prepared—with the recent significant selloff in equities and bonds, the market has repositioned valuations for a more hawkish environment. But a more in-depth analysis of the Fed’s chosen timeline tells us something else rather important as well.
To explain this, let’s go back in time. If you recall, the COVID-19 pandemic went global in late January 2020 and effectively hit the United States in late February, with lockdowns spanning the country in March. March 2020, then, was a time of significant price slowdown and temporary deflation as people were stuck at home, unable to spend on pretty much anything but essentials. Because March 2021 price gains on a year-over-year basis were compared to March 2020, they looked like a spike at the time: hitting 2.5%, ahead of the sub-2% that were seen in January and February 2021 (when prices were anniversaring pre-COVID-19 lockdown times).
Things got worse throughout 2021 as more vaccinations meant more people consuming and supply chain bottlenecks caused prices to rise, which means that inflation will have tougher and tougher comparables throughout 2022. But those tough comps begin in March—and the Fed is aware of this, which is why March is an excellent time to start raising interest rates.
The reason why that timing is so good is clear: the 7% yoy increase in prices in December 2021 is unsustainable and, economically speaking, disastrous if it lasts too long. That’s the primary reason why the Federal Reserve is planning to raise rates four times in 2022. But if the yoy inflation numbers start to moderate in March as comps get tougher, the Federal Reserve will have more room to delay rate hikes if it so chooses, which itself could moderate any anxiety about them moving rates too fast and causing a recession.
The selective clarity and careful vagueness on different aspects of its actions are so subtle that most people will not notice it—but those who are well versed in the Fed know exactly what they are doing, and the central bank’s careful choice of verbiage to position itself as best as it can for 2022 is both an impressive feat for Powell et al. and a sign that the system is working very well.
