The Federal Reserve on Wednesday sent a clear message to markets: Prepare for interest rate hikes next year.
In its final policy-setting meeting of 2021, the Federal Open Market Committee published projections for where its 18 members could see interest rates going next year.
All 18 see the case for at least one 25 basis point hike next year, with the median member forecasting three rate hikes before 2022 is over. The Fed on Wednesday laid out the game plan: end the Fed’s program of asset purchases in a few months, and then focus on rate policy to quell unwanted inflationary pressures.
“We’re in a position where we’re ending our taper by March, in two meetings, and we’ll be in a position to raise interest rates as and when we think it’s appropriate,” said Fed Chairman Jerome Powell at a press conference Wednesday afternoon.
Just three months ago, the Fed had been on the fence about rate hikes. In the FOMC’s September meeting, the committee was split 50-50 on whether to lift rates off from the current target range between 0% to 0.25%.
Wall Street analysts very quickly adjusted their forecasts for interest rates next year due to the “hawkish” surprise of a Fed more eager to normalize policy than expected.
At BofA Global Securities, analysts said they now expect the first rate hike to come in March as opposed to their previous call of liftoff in June. Evercore ISI agrees that a rate hike as soon as March is on the table.
“We read the Fed statement and the SEP as on the hawky side of hawkish expectations going in — including with a three hike baseline for 2022 — though not to an extreme degree and some components go the other way,” wrote Evercore ISI’s Krishna Guha on Wednesday.
Fed funds futures contracts quickly re-priced. Bets on Fed actions priced in a 40% chance of a rate hike in March 2022, a step up from the 31% odds priced in prior to Wednesday’s meeting.
Hiking into a flat curve?
Powell did not appear concerned about the environment into which the Fed may be hiking rates.
High inflation readings are now pushing Fed officials into a more proactive stance on drawing down its pandemic-era stimulus. Although the labor market still has under 4 million people out of work compared to February 2020 levels, the Fed is encouraged by labor market reports that continue to show payroll gains and lower unemployment rates.
Bond markets, however, may be questioning the Fed’s ability to raise rates without triggering an abrupt end to the recovery.
The yield curve, which maps out the yields of U.S. Treasuries across different durations, serves as a proxy for investor bets on future growth prospects. Generally speaking, higher longer-term bond yields (and a steeper curve) correspond with optimism over longer-term conditions.
But several yield curve measures show a flatter yield curve. For example, the difference between the U.S. 2-year and the U.S. 10-year Treasuries fell to as little as 75 basis points at the beginning of the month. When that difference falls below 0, markets usually brace for a recession.
If the Fed lifts rates on the short-end, that could tilt the 2-year yield up. If the 10-year yield doesn’t also rise, the spread could get closer and closer to flashing that recession signal.
The 10-year U.S. Treasury yield (^TNX) traded at 1.46% on Wednesday afternoon, about 20 basis points below where it was trading at the end of November.
Responding to a question from Yahoo Finance, Powell said Wednesday longer-duration bond yield dynamics are likely due to global factors. With yield low on 10-year Japanese Government Bonds and negative yields on German 10-year bunds, Powell said the demand for U.S. Treasuries are keeping rates low.
“I’m not troubled by where the long bond is, I see that it’s low. We’re really focused on broader financial conditions, focused on maximum employment, price stability,” Powell said.
The next FOMC meeting is scheduled to take place on Jan. 25 and 26.
Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.
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