Fed is managing market expectations well
Abraham George Macro Musings
Finally, the Fed acted on doubling up in withdrawing the emergency QE program. I widely expected this to happen. The market reacted positively to that too. That must have been a bit contrary to many of the other market watchers’ expectations. I’ll come to that in a bit. But, let us backtrack to what transpired in previous tightening cycles.
Fed Chairman Jay Powell had given enough clues from the November Fed meeting that the Fed could speed up the timeline on ending QE. So yesterday’s announcement should really not be a surprise to anyone. It would have been if he’d backtracked from his November indications. It was very clear that the Fed was unlikely to start any official tightening before ending the QE program. Until the day before yesterday, the market was expecting a 30% chance of tightening in March and a 50% chance in May. With yesterday’s announcement, those chances have increased substantially.
Remember in the hot inflation spikes of 1973-1974 and in the 1980s, the Fed had to increase rates above the inflation rates to finally get it under control. Going by the same analogy, in the current situation, if inflation is running close to 7%, you know very well how much the Fed has to tighten to get inflation under control.
The Fed is riding on many optimistic expectations too, like for example the supply chain bottlenecks will be worked out on their own over time and naturally the inflationary pressures will ease. But what if it worsened, with all the political upheavals that are happening around the world.
The government’s mandate to the Fed is to bring inflation under control without killing the economic expansion. That is way too much wishful thinking and given the current situation, it will be a very tough task. Therefore, Powell is between a rock and a hard place. Compound to that, as the economy opens up, the more than $5 trillion of new money supply added in the last 20 months or so should create imbalances and confusion for the Fed.
On balance, I think the Fed will hike in March 2022. Though the Fed will start sounding more hawkish from now on, the Fed will be aiming for a shallow rate hiking cycle as the expectations are too high for things to level off on their own. What the Fed has done so far based on its recent history is that they have successfully managed the market’s expectations and has been very poor at market forecasting. Look what happened in 2015 and 2016. So, markets are happy with how the Fed has handled so far but it won’t be long before they run into a brick wall. The Fed always has the right to change their mind like how they did with the ‘transitory’ rhetoric. One thing is for sure - 2022 is not going to be as easy and smooth for market participants as it has been in 2021.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office and a hedge fund. Currently, he is setting up a hedge fund where foreign citizens can invest in Indian growth stocks like Tanla operating in hyper-growth markets like CPaaS.