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BY Greg Nini, Drexel University

Thoughts on Monetary Policy

During the first quarter of 2022, the Federal Reserve began the task of removing the proverbial punchbowl that has been nourishing the U.S. economy and financial markets since the onset of the COVID-19 pandemic. In a widely expected move, the Fed on March 16 increased their target interest rate by 25 basis points, raising the federal funds rate off the floor for the first time the since April 2020. Faced with very high measures of inflation and, in the words of Jay Powell, an “extremely tight” labor market, the Fed has begun the process of tightening monetary policy. Based on the Fed’s projections, short-term interest rates are expected to rise by an additional 150 basis points by the end of 2022 and another 100 basis points by the end of 2023. If all goes as planned, the increase in rates will be far faster and slightly higher than the previous tightening cycle from 2016 through 2019. The Fed also announced the end of quantitative easing and will instead begin to reduce their holdings of Treasury and related securities.
The Fed began telegraphing their change in policy early in 2022 as mounting evidence confirmed that inflationary pressures are widespread and persistent. Since the release of the Fed’s economic projections in December 2021, the Fed has revised its forecast of their preferred measure of inflation in 2022 from 2.7% to 4.1% and predicts core PCE inflation to remain above their 2% target in 2023 and 2024. Despite tighter monetary policy and falling inflation over the next couple years, the Fed still forecasts nominal GDP to grow over 7% in 2022 and nearly 5% in 2023, and the unemployment rate is expected to remain around 3.5%.
During the first quarter of 2022, market yields largely increased in response to the expectation of tighter monetary policy. As shown in the figure below, two- and ten-year yields on nominal Treasury securities increased 155 basis points and 80 basis points, respectively, reflecting the higher near-term path of the federal funds rate. Roughly one-third of the increase in the 10-year nominal yield is attributable to a rise in compensation for inflation, as inferred from the breakeven inflation priced by TIPs. However, forward-looking measures of inflation compensation remained steady at about 2.3%, suggesting that markets anticipate the Fed to bring inflation under control, at least within the next five years. Borrowing costs for municipalities, firms, and homeowners also increased during the quarter, due both to an increase in government yields and a widening of spreads relative to Treasury benchmarks.
Built into the Fed’s plans is a very slow and orderly removal of the punchbowl, with minimal impact on the broader economy. With core PCE inflation having hit roughly 5% in 2021, the Fed is hoping to cut the rate in half by 2023 without hurting the labor market. Notwithstanding further geopolitical or other macro shocks, avoiding damage to the economy seems feasible given that monetary policy is expected to remain supportive through 2023. Despite the forecasted increases in the nominal federal funds rate, the real federal funds rate – the policy rate less PCE inflation – is expected to remain negative in 2022, roughly zero in 2023, and only reach the longer-run level of 0.5% in 2024. If such gradual easing of policy is sufficient to reduce inflation remains to be seen, but it seems clear that, although the punchbowl may be shrinking, the bar remains fully stocked.
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Note: Data on nominal Treasury yields and breakeven inflation is based on data from the Federal Reserve as reported in Federal Reserve Economic Data (FRED). Corporate bond yields are based on the ICE BofA BBB US Corporate Index Effective Yield as reported in FRED, and the mortgage rate is the 30-year fixed rate mortgage average in the United States from Freddie Mac, as reported in FRED. The municipal yield is based on the ICE/BAML composite yield taken from FactSet.
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