By Ellen Gaske, head economist – G10 economies at PGIM Fixed Income
The Fed appears poised to lift the Fed funds rate by 25bps at its March meeting – or at its May meeting – followed by, in our view, two additional rate hikes this year. The market at this point is almost fully priced for lift off in March and for four full hikes over the course of this year.
We still expect Fed rate hikes will likely fall somewhat short of market pricing this year, although we think there are two-way risks around our base case of three rate hikes. If inflation remains stubbornly high and a price/wage spiral continues to pose a risk, Fed tightening could well wind up being more aggressive than we now expect.
But given our projection that economic growth and inflation are likely to soften somewhat on their own over the course of this year, the Fed may ultimately find it prudent to slow down its pace of tightening later this year, particularly if it is also launching an early start to quantitative tightening (QT).
Echoes of 2017-19
We suspect, just as in the 2017-2019 QT period, the Fed may well stop short of fully unwinding its QE purchases of the last two years. Although precise projections are difficult – particularly as details around the Fed’s plans for QT are yet to come – the Fed could perhaps be done with its QT after about two years or so.
Similar to last time, the notion QT will have a finite life is a factor markets undoubtedly will factor in. While the potential for a more rapid timeline for implementing QT has surprised us – we had thought a 2023 start was more likely – a QT start later this year may come at an opportune time, given the US Treasury’s planned cutbacks in coupon issuance this year. But given the likelihood QT will be occurring alongside Fed rate hikes, the combined tightening may appear sufficient earlier in this cycle as well. If aggregate demand conditions moderate this year as we expect, and supply disruptions improve, inflation and GDP growth may be naturally moderating by the second half of 2022.
With the torrid pace of re-openings behind us, no significant additional fiscal boost on the horizon, and current high inflation rates eating into household purchasing power, we expect inflation will likely have moderated by the end of this year. If so, this should ease pressure on the Fed to ramp up its planned tightening campaign further and sow the seeds for the Fed funds rate to reach a cycle peak of perhaps 1.5-2%, and for QT to end as well.