FOMC Could Opt Cautious Rate Policy Amid Ukraine Uncertainty

Federal Reserve officials next week will raise interest rates for the first time since 2018 and signal a faster pace of hikes in 2022, though policymakers may be cautious amid uncertainty due to Russia’s invasion of Ukraine.

While markets expect six or seven hikes this year spread out during the Federal Open Market Committee’s remaining seven meetings, economists say the Fed’s quarterly forecasts in the dot plot will show around four hikes for 2022 and they predict the Fed will follow through with five increases with no half point moves.

Investors have ramped up expectations for an aggressive Fed posture in the face of the highest inflation in four decades. But the economists say the outlook has become muted by uncertainty over Ukraine, sanctions and surging commodities prices. The economists predict the Fed may raise rates by 1.25% this year, with rates reaching 2.5% in 2024.

There is much higher uncertainty than normal about the course of Fed policy amid many crosscurrents, the Fed is likely to be somewhat more cautious and dovish as a result than it would have been otherwise.

Fed Chair Jerome Powell told lawmakers last week he would recommend a quarter-point rate hike at the March 15-16 Federal Open Market Committee meeting, leaving little doubt in the view of economists that is the plan.

Yet he’s been vague about the pace of future increases and whether the policy group will consider larger half-point hikes. The survey of 42 economists was conducted March 7-10.

Powell said the Fed would do what was necessary to cool price pressures, while cautioning that Russia’s invasion of Ukraine was a source of great uncertainty that had driven up oil prices. That would push inflation even higher, but also potentially hurt growth.

The turn to a more aggressive policy stance has been driven by surging inflation and a robust labor market, which Fed officials consider to be at or near full employment. The FOMC is likely to raise its inflation forecasts for 2022 to 3.9% from 2.6% in December, and trim its growth for this year to 3.3% while continuing to see unemployment rate staying around 3.5% for the next several years, according to the survey.

The Federal Reserve is walking a tightrope, balancing the risks of a more entrenched and persistent inflation against a triggering a larger meltdown in credit markets.

The price surge is leading some officials to openly discuss raising rates by a half point, rather than the typical quarter-point increments, to position rates to slow the economy and inflation. According to the survey, 15% see the FOMC raising rates by a half point at at least one meeting this year, while 85% see more gradual moves as the likely path.

In addition to raising rates, the FOMC plans to shrink its nearly $9 trillion balance sheet later this year, after completing purchases this month that were intended to provide support to the economy during the covid-19 economic crisis. While the FOMC unveiled some general principles, including that shrinking would happen after rate liftoff, many details remain to be worked out.

The FOMC is likely to start the asset reductions with roll-off of maturing securities between July and September, according to 54% of the economists. By December, the balance sheet is likely to drop to $8.5 trillion and by another $1 trillion a year after, they predict.

With housing and rental prices surging, the FOMC may choose to let mortgage-backed securities to run off faster than Treasuries, according to 38% of the economists. Fifty-four percent say the Fed will let them run off at the same pace.

While surging inflation since October has gradually forced the pivot among FOMC leaders, the economic outlook has gotten more uncertain in recent weeks with Russia’s invasion of Ukraine, sparking global sanctions and a huge run-up in commodity prices.

Powell in his congressional testimony repeatedly cited the Russian-Ukraine war as an uncertainty clouding the outlook and requiring nimbleness on the part of Fed leaders. All of the economists expect the FOMC to include a reference to the war in its March statement, with 45% of respondents saying it may prompt policy makers to be slightly more dovish.

To the extent the Russian invasion of Ukraine raises energy costs and therefore inflation, there is little the Fed can do short of slowing the economy sharply, which is not likely. To the extent it raises the risk of a major slowdown, the Fed may be more cautious in raising rates. This Fed is likely to err on the side of caution rather than aggressiveness.

While the FOMC clearly signaled its plan for March liftoff in its January statement, economists have mixed views on whether the March statement will include forward guidance on rates.

About 28% see the committee indicating its plans for another hike in May and 45% think the group could signal a string of increases in the statement, while 28% think the statement will include no guidance.

Economists disagree on what constitutes the biggest risk facing the Fed. About 23% say the Fed will be too slow to tighten credit and allow elevated inflation to become embedded in the economy, while 28% say the central bank being too aggressive with rates and prompting a recession is the larger concern. The rest say they are equal risks.