The Fed faces 'so many unknowns' now as it digs in to fight against inflation

Published Thu, Mar 17 20223:01 PM EDTUpdated Thu, Mar 17 20223:42 PM EDT

Federal Reserve officials made a stand Wednesday, switching from champions for employment equality to fighters of inflation. To do so, they pointed to a unique and aggressive path that will see it not only raise interest rates but also siphon off some of the $8 trillion in easing provided over the last 14 years. The lingering question will be whether they actually can pull it off. The last time the Fed tried to normalize monetary policy, the results were unconvincing. After raising rates nine times from 2015-18 and reducing its balance sheet by $800 billion, they had to call off the dogs due to a global economic slowdown and a market revolt. Ultimately, a pandemic then forced policymakers back down the same road they took during the financial crisis. The Fed on Wednesday signaled that it will be able to raise rates 10 times — in less than two years — and cut what likely will be trillions off the balance sheet. But even with a stronger economy and a phenomenally tight labor market , the task will not be easy. "The markets are pricing in an aggressive pace of rate hikes. We're seeing risk assets kind of hang in there. That's a good thing," said Collin Martin, fixed income strategist at Charles Schwab. "That does give them the runway to hike aggressively if need be. The bad news is there are so many unknowns out there. That could pose a risk to the aggressive pace of rate hikes." Looming largest among those risks is the war in Ukraine and the accompanying fears of global warfare and added complications to supply chains and the energy picture. What the Fed did this week, though, was to address the market's other main concern, namely the generational highs in inflation that threaten an otherwise solid U.S. economic picture. A two-pronged approach that leaves questions Central bankers left little doubt that they're ready to attack with all the tools at their disposal. They include rate hikes — projected at seven total this year and three more in 2023 — plus a balance sheet rundown that Wall Street expects to run at a pace of about $80 billion to $100 billion a month. "The new projections still seem a bit too aggressive for us, but that being said, they clearly overdelivered," Martin said. For now, at least, investors seem satisfied with the new inflation-fighting posture. Stocks have staged a strong three-day rally , indicative that risk assets could keep rising under the new Fed strategy, while bond yields tumbled Thursday , pointing to a belief that the tightening will help keep inflation in check. Those are just knee-jerk reactions, though, and Fed policy operates over the long haul. "People get far too obsessed with the idea of rate hikes, but the rate hike is purely a signaling mechanism," said Julian Brigden, president of Macro Intelligence Partners, a macroeconomic research firm. "We don't care about what you get in overnight repo rates. What we care about is how that manifests itself in the broader economy." Brigden sees a complicated landscape ahead for the Fed, which he thinks may be forced to use the balance sheet to meet its goal of tighter financial conditions that will slow the economy and subdue inflation. If the Fed gets too aggressive with the balance sheet, it could "crater asset prices," he said, citing conversations he said he's had with traders. "If the Fed hikes the funds rate and the equity market doesn't respond and financial conditions don't tighten, does it matter? The answer is no, it doesn't," Brigden said. "I really think the biggest takeaway from this was the possibility that the balance sheet will start to shrink in May." Watch the minutes Indeed, Fed Chair Jerome Powell even advised the media at his post-meeting news conference Wednesday to watch minutes from this week's two-day session for clues about the future of the balance sheet. He also indicated that the reduction could start in May, which is at least a month or two sooner than Wall Street had expected. Under the course the Federal Open Market Committee charted, the May meeting also is likely to see another 25 basis point rate hike. Starting the balance sheet runoff at the same meeting seemingly would take a 50 basis point increase off the table, though some aren't so sure, particularly if inflation data continues to run hot. Citigroup has kept up one of the more hawkish Fed forecasts on Wall Street and sees an even more aggressive path ahead. "The thinking is that the Fed would not want to deliver two hawkish messages in one meeting by hiking faster and announcing the balance sheet," Citi economist Andrew Hollenhorst said in a Thursday note. "Like so much else, we think inflation changes this logic. Rather than avoiding being 'too hawkish" Fed officials will want to be seen a strongly responding to the inflationary environment." However, the Fed might not like the outcome, according to Tom Porcelli, chief U.S. economist at RBC Capital Markets. "Here's the thing. Powell used this same sort of approach/rationale last year when he was focused on labor over inflation," Porcelli wrote. "He was going to help the labor backdrop at all costs. Fair to say we are paying the price for that approach today? And now he wants to employ this same rigid approach with inflation. What price will we pay for that approach in the coming months? Inflation over growth at any cost it would seem, even if that cost is a meaningful slowing in growth."

Federal Reserve Board Chairman Jerome Powell waits for the beginning of a hearing before Senate Banking, Housing and Urban Affairs Committee on Capitol Hill November 30, 2021 in Washington, DC.

Alex Wong | Getty Images

Federal Reserve officials made a stand Wednesday, switching from champions for employment equality to fighters of inflation.

To do so, they pointed to a unique and aggressive path that will see it not only raise interest rates but also siphon off some of the $8 trillion in easing provided over the last 14 years.

The lingering question will be whether they actually can pull it off.