How Will the Federal Reserve Conduct Monetary Policy after March?

The Federal Open Market Committee meets in the U.S. on March 15-16. While a rate hike is expected, what path will the Federal Reserve take on monetary normalization in the future amid the chaotic situation in Ukraine? We asked Ryo Ono, a principal at Mizuho Research & Technologies, who has long analyzed the United States economy and monetary policy.

The FOMC is expected to enter an interest rate hike phase. Russia's invasion of Ukraine has increased uncertainty, but what will happen to the Fed's policy in the future?

In his March 2 testimony to Congress, Federal Reserve Chair Jerome Powell clarified the monetary policy to be decided at the March FOMC meeting. Commendably, Powell tried to eliminate as much uncertainty as possible on the monetary policy front, partly due to Russia's invasion of Ukraine. Since the situation in Ukraine is not having an immediate impact on the United States economy, the Fed will probably raise rates by 0.25% as planned.* This will be the first of a series of rate hikes, and the Fed will not begin shrinking its balance sheet until after the May FOMC meeting, probably in June, in my view.

The decisive difference between America and other countries is the strength of the economy. According to the January data, there is a labor demand that exceeds the number of available workers in the Job Placement Change Survey by 5 million. In the employment statistics for February, the number of nonagricultural employees increased by 678,000 from the previous month, and the three-month moving average of 582,000 was a considerable pace. The unemployment rate also fell below 4%. Wages have also increased in the range of 5%.

The last time the country entered a rate hike phase was in December 2015, and it is by far stronger than at that time. This reflects historic strength in domestic demand. The fact that domestic demand and external conditions are both strong is the difference between the situation faced by the Fed and that confronting the European Central Bank and the Bank of Japan.

Consecutive Rate Hikes at All Meetings after May

Powell also mentioned that interest rates are higher than neutral rates. What is the path for future rate hikes?

I think that Powell acknowledged the possibility of exceeding the neutral interest rate in order to avoid uncertainty. The peak policy rate will be brought forward from the end of 2024 to the end of 2023, and in the words of Powell, “Frankly, the need is one of getting rates back up to more neutral levels as quickly as we practicably can, and then moving beyond that if that turns out to be appropriate.”

The FOMC on March 15-16 will revise the quarterly economic and policy rate outlook. It will revise the outlook for inflation upward, since inflation has been on an upward trend for several months, and it will also raise the policy rate outlook, the so-called dot chart, significantly from the level indicated last December. Specifically, it would not be surprising if the policy rate level at the end of 2022 is between 1.75% and 2.00%, indicating that the policy rate will be raised consecutively at all meetings after May.

However, this is only the current outlook based on the situation in Ukraine. It could swing up or down in the future.

Chairman Powell will treat the dot chart somewhat lightly, not as a decision or forecast by the FOMC, but merely as individual forecasts by FOMC participants. He is likely to explain that future monetary policy will be fluid and live, in the sense that they do not know what will happen.

If it were not for the situation in Ukraine, the dot chart would have been used more aggressively for market incorporation and confirmation with the market, but this time, I think they want us to put less emphasis on the dot chart.

Since they are aware of predictability, they are basically raising rates by 0.25% every time. This is not to deny that the increases will reach 0.50%, so they could raise rates earlier this year, but in that case, they would suggest the increases in advance and factor that into the market rather than issuing it as a surprise, like Alan Greenspan did in 1994.

The Balance Sheet Will Be Reduced over the Next Year, Starting in June

What will the pace of quantitative tightening look like?

Basically, the balance sheet has doubled compared to the last quantitative easing. I think it means that easing will be reduced at twice the pace as last time, when it was reduced from September 2017 to September 2019. In about a year, they will increase the reduction in reinvestment of redemption proceeds from government bonds and mortgage-backed securities; a year from then,, the reduction would be almost constant. The last time this happened, the total was $10 billion — $6 billion for Treasury bonds and $4 billion for mortgage-backed securities. They will probably double that amount to a total of $20 billion. The maximum reinvestment was $50 billion last time, so it will probably be $100 billion this time.

While some in the market are concerned that high inflation will lead to a risk of stagflation, others see the Fed’s tightening as overkill for the economy.

It is true that inflation robs households of purchasing power; the question is the degree to which it does so. While the market has been blinded by the nearly 8% increase in the Consumer Price Index in February, the growth in wages is even greater. The February employment report puts the growth in employment compensation at around 10% as of February.

One of the sources of the large growth in real income is the trade gains that are now a hot topic in Japan. Between last October and December before the invasion of Ukraine, Japan's trade gains were minus-9.4 trillion yen (approximately $77.2 billion), or minus- 13.8 trillion yen (approximately $113.3 billion) year-on-year, indicating a large outflow of real income overseas. The income environment of the Japanese economy, or real gross domestic income, is even more fragile than when viewed in terms of real gross domestic product.

Economy under High Inflation Is Still Strong; If Anything, the U.S. Should Strengthen Tightening

In addition, United States households had a flow buffer of a 6.4% savings rate and a stock buffer of $3.1 trillion in liquid assets at the end of last year. This is the upside of the 2010-2019 trend for settlement deposits and savings deposits.

In light of this, we cannot ignore the possibility that the United States economy will remain strong even under high inflation rates and, in fact, that the Fed's gradual tightening will not be enough to cure inflation in time. While the situation in Ukraine may force the FOMC to take a wait-and-see approach, we can also envision a scenario of consecutive 0.50% rate hikes.

In terms of energy, sanctions on Russia will hurt Russia and Europe, but I think it will work more positively for the United States.

This is true in terms of energy. The OPEC share and the United States share in the market will increase. Europe will not be able to sustain itself if it does not replace reduced imports from Russia.

However, as seen in the nickel problem, the shortage of mineral resources will also grow. In the midst of these various difficulties, the size of foreign direct investment in Russia is $400 billion, which is quite likely to affect the securitized market and put stress on the financial markets.

The United States is strong with regard to energy, but it is sensitive to credit shocks in financial markets, so it is possible that the economy will experience zero growth in the first quarter of 2022. However, it does not mean it will continue to worsen. It has the potential to recover in the next term.

The Biggest Risk Is the Shutdown of Natural Gas from Russia

Russia is still supplying natural gas to Europe, and if this were to stop, it would be a disaster. German Chancellor Olaf Scholz has said there is no alternative.

Shutting down gas supplies to Europe is a pretty risky situation, and it has been less than a month for both Russia and Europe. It would be a blow to the global economy, including the United States economy in view of the financial markets; it is expected that the direction would be to finalize cease-fire talks before going there.

In that case, the talks would include not only Ukraine and Russia, but also the European Union. The Minsk Agreement, a 2014 peace agreement between Russia and Ukraine related to the conflict in eastern Ukraine with France and Germany as mediators, was very ambiguous and will not resolve anything without a fresh start.

*Editor’s note: The Fed approved a .025% rate hike on March 16.