The devil “is in the details,” as the old saying has it, though long-time watchers of the U.S. Federal Reserve (Fed) might include the Fed chair’s post-policy meeting remarks as another potential hiding place. That was the case at the conclusion of the Fed’s two-day policy meeting on January 26. After the policy-setting Federal Open Market Committee (FOMC) issued a statement that contained no substantial surprises, Chair Jerome Powell tacked to a more hawkish stance during his post-meeting remarks to the press.
In response, short-term interest rates rose quickly after Powell’s comments on January 26: the bond market factored more than four 25-basis point (bp) hikes in the fed funds rate by early next year, while the yield on two-year U.S. Treasury notes rose more than 15 bps from pre-conference levels even as the yield curve flattened.
While these seem like rational market responses to a change in the likelihood of Fed hikes, it is also clear that much of this hawkish tilt was expected by the market, and largely priced in. Moreover, the market has avoided the panic-selling that often accompanies hawkish surprises. Why? A closer reading of Powell’s comments suggest that he is focused on increasing flexibility in responding to the various economic challenges ahead, rather than locking the Fed into a course of action that might undermine the economic recovery.
An Emphasis on Inflation Risk
In the press conference, Powell emphasized that the U.S. economy was much more inflation-prone than it was during the 2016-18 tightening cycle, and that this would require the Fed to shift to a policy that was not accommodative to help preserve the economic expansion.
All the actions that Powell mentioned—ending asset purchases in early March, raising rates at the March 15-16 FOMC meeting as a first installment in a series of hikes, and, potentially, allowing maturing securities to roll off the Fed’s balance sheet after the June FOMC meeting—were already factored in by markets to varying degrees. But his emphasis on the position that the labor market had tightened beyond full employment and that inflation risk was distinctly to the upside, and his assertion that monetary tightening would be needed to contain it, made it plain that the FOMC had moved decisively to prioritizing inflation control over its other objectives.
Powell also noted that the FOMC was satisfied with its messaging to the markets judging from the response after the December 2021 policy meeting and release of the minutes in early January. Inasmuch as that response consisted of a continued tightening in financial conditions, as evidenced by pullbacks in major fixed-income and equity indexes, it appears the Fed is not troubled by the downward adjustment in risk asset prices but sees this development as an inevitable consequence of bringing inflation under control.
While Powell did mention, repeatedly, that fiscal policy and supply chain improvements would help bring inflation down in coming periods, it was clear that he didn’t think that would be enough. And while he also alluded to two-sided risks, i.e., the tension between controlling inflation and maintaining strong economic growth, he clearly put the lion’s share of the emphasis on the downside risk from inflation remaining too high.
Powell summarized the Fed’s approach thus: