US Federal Reserve is getting ready for a turnaround in interest rates - "Inflation problem number 1"

Created: 01/25/2022, 17:18

Observers expect the US Federal Reserve to make important decisions regarding balance sheet reductions and interest rate hikes.

© Liu Jie/XinHua/dpa

Inflation has the United States firmly in its grip.

The US Federal Reserve will discuss the situation on Tuesday and Wednesday.

Experts expect that the monetary watchdogs will hardly be able to avoid an imminent turnaround in interest rates.

Washington DC/Berlin – The US Federal Reserve is preparing the financial markets on Wednesday for the interest rate turnaround* expected in March.

The discussion at the monetary policy meeting probably revolves around the question of how much the price of money has to rise in order to curb inflation.

In view of the inflation rate of 7.0 percent recently, investors are puzzled as to whether the monetary watchdogs are considering an increase of a quarter of a percentage point or even half a point.

For the time being, they will most likely keep the key rate in the range of zero to 0.25 percent on Wednesday.

Turnaround in interest rates in the USA: important decisions expected

However, US Federal Reserve Chairman Jerome Powell has signaled that the loose line will soon be over, as the economy no longer needs help in the upswing. At the same time, he conceded that the central bank's balance sheet, which was inflated due to the bond purchases during the virus crisis, is larger than it should be. Observers therefore expect the two-day meeting of the Federal Open Market Committee (FOMC) ending on Wednesday to set the course for balance sheet reductions and a turnaround in interest rates. This is referred to as a "lift-off" in American central banker jargon, based on a rocket launch.

Therefore, the January meeting will most likely serve as the last test for the actual start, explains DWS economist Christian Scherrmann: “The central bank meeting will therefore be the last update before the Fed ignites the interest rate rocket.

The countdown is on.” The economist is currently not assuming that the Fed intends to catapult interest rates up by half a percentage point, i.e. 50 basis points.

But inflation could force them to act.

"If inflation continues to rise in January and February, the Fed could come under enormous pressure and react with a rate hike of more than 25 basis points."

The Fed should promote stable prices and full employment

This would be a very unusual move for the Fed, last seen in May 2000.

At that time, it raised the key interest rate by half a percentage point to 6.5 percent.

The Fed should promote stable prices and full employment.

KfW chief economist Fritzi Köhler-Geib points out that the US job market, with an unemployment rate of 3.9 percent recently, has come closer to the pre-crisis level of 3.5 percent: “This enables the Fed to fight rising prices focus."

Material shortages resulting from the Corona crisis and high energy costs have been driving inflation for a long time.

Alarmed by inflation soaring to a 40-year high, several US monetary authorities have called for a series of rate hikes this year.

The financial markets expect up to four steps upwards.

The Fed's trillion portfolio is set to shrink

"High inflation is now the number one problem for the Fed," said Commerzbank economist Bernd Weidensteiner.

That's why she started reducing her bond purchases in November.

In March, she will probably stop making purchases completely.

“The central bank should confirm this schedule.

At the same time, it will probably give a clear signal that the conditions for a first rate hike in March should be in place.”

Powell has already pointed out that the Fed is also likely to start shrinking its balance sheet this year.

This process will probably take place at a faster pace than on previous occasions.

Weidensteiner calculates that the central bank's securities portfolio has grown from almost $3.8 trillion to $8.4 trillion since the end of 2019.

In comparison to the years after 2010, the economic recovery after the corona shock is proceeding “in fast motion”.

At the same time, inflation is much higher: "We therefore expect normalization to begin quickly and expect the relevant decision to be taken at the May meeting."

The Fed is likely to reduce its securities holdings again* by not reinvesting all maturing bonds.

This can be shown without any problems, since the Fed's portfolio also has high maturities in the short term.

Over $1.1 trillion in Treasuries held by the Fed would mature this year.

(rtr)