On Wednesday, the Federal Open Market Committee (FOMC) will unveil its most anticipated monetary policy decision in recent memory. Federal Reserve (Fed) officials face an extremely challenging balancing act as they seek to tighten policy in response to generationally-high inflation and tight labor conditions in the U.S. However, the central bank will also have to consider the impact of Russia’s invasion on growth as well as a flat U.S. Treasury yield curve that is signaling growth concerns.
If last week’s European Central Bank meeting is any indication, global policymakers are most keenly focused on wrangling inflation and restoring some policy flexibility. Specific to the U.S., February’s Consumer Price Index showed price growth was accelerating even before the impact to energy prices from Russia’s invasion. That leaves the Fed in a difficult position. We expect the Fed to move forward with raising rates by 0.25% on Wednesday in the face of elevated uncertainty and market volatility. It is likely the Fed will accompany the shift with forward guidance that acknowledges the need for maximum flexibility as it formulates policy given the widening range of potential economic outcomes.
Additionally, the Fed’s policy tools are less-than-ideal for combatting the supply disruptions behind the U.S.’s inflationary pressures. The central bank can raise rates to cool off some of the fervent demand, but rate increases are little help to rebuilding global supply chains. Given the options on the table, we expect the Fed to incorporate balance sheet reduction to put upward pressure on longer yields in an effort to preserve a healthy curve as it cautiously raises interest rates. Such a strategy gives the Fed the best chance of reducing accommodation without adding to recession fears.
A look back
- Global stocks were dragged down by the U.S. and emerging markets as geopolitical tensions and rising recessionary fears weighed on markets last week.
- U.S. yields rose in response to the energy supply shock created by the Russia-Ukraine conflict and signs that inflationary pressures are broadening. 10-year yields are the highest (2.09%) since mid-2019.
- Market-based inflation expectations jumped to new highs after February Consumer Price Index data accelerated to 7.9%. On Friday, 10-year breakeven rates eclipsed 3% for the first time since at least 1998.
A look ahead
- Global markets remain on edge as the Russia-Ukraine war continues. A fresh round of talks between the two countries is expected. Participants are closely watching China’s involvement.
- Despite rising geopolitical uncertainty, the FOMC is expected to hike rates at its meeting on Wednesday for the first time since late 2018.
- Economic releases: FOMC rate decision, Retail Sales, Industrial Production, Housing Starts, Existing Home Sales, Producer Price Index, Leading Index, and Empire Manufacturing.
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