The Fed firm in its rhetoric, less so in its actions

Comments by Franck Dixmier , Global CIO Fixed Income at AllianzGI, ahead of the FOMC meeting on 25 and 26 January?

Key takeaways

• We expect a strong speech from the Fed on its will to fight inflation, but no concrete announcement apart from the confirmation of a first rate hike in March at the FOMC meeting of the 25-26 January.
• The Fed could, however, confirm its intention to start reducing its balance sheet in the second part of the year, as indicated in the Minutes of the December meeting.
• Given market expectations, this FOMC should not influence the direction of rates and markets.

In the last six months, the US Federal Reserve (Fed) has made a major change in strategy: inflation, which it had struggled to characterise for much of 2021, has become its main concern. That shift is well illustrated by the December Monetary Committee Minutes. These have indeed revealed a more hawkish Fed than expected, particularly on employment, of which it notes the “very tight” market. They also signaled a willingness to hike rates sooner and faster than initially expected. Some Federal Open Market Committee (FOMC) members even suggested starting to shrink the Fed's balance sheet. Since then, the publication of inflation at 7% year-on-year in December can only reinforce the need for a less accommodative monetary policy.

It remains to be seen whether this shift is really sincere, as the dichotomy between the power of the speech and the current inaction is strong. In fact, beyond the rhetoric, it is difficult to detect the slightest sense of urgency to implement a tightening of financial conditions. Admittedly, the Fed has begun its tapering, but it continues to buy assets in the market, even though there is no economic argument for doing so. And why wait until March to raise rates? The constraint of waiting for the end of tapering, scheduled for March, to raise rates was set by the Fed itself….

The Fed appears to us to be losing its bearings. The evolution of inflation continues to be difficult to characterise. Despite the arguments in favour of a decline in inflation in the second half of the year, the persistence of the health crisis, and the zero-Covid strategy of certain countries, in particular China, could cause further disruption of production chains, maintaining upward pressure on prices. Moreover, the Fed is caught between strong political pressure to raise rates to counter inflation and its hesitation to tighten financial conditions in the context of a slowdown in the American economy in 2022. In fact, after a significant catch-up in 2021, demand for goods is expected to slow as real wages are now negative, and public demand will benefit from less fiscal support. Finally, if the arguments for raising rates are met, the level of increase is less obvious to determine for a Fed fearing a monetary policy error.

We, therefore, expect a firm speech on the tightening of its monetary policy to counter inflationary threats, but no concrete announcement apart from the confirmation of a first rate hike in March. The Fed's objective at the FOMC meeting should be to buy time, and therefore visibility for its economic forecasts to regain credibility.

This meeting should have no impact on the markets. In recent months, they have revised their expectations upwards, with five rate hikes planned for 2022, which has already led to a correction across the entire curve.

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