Supported by the market and the economy, the Fed may raise interest rates for the first time in two months

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The Marriner S. Eccles Federal Reserve Building in Washington.

Stefani Reynolds/Bloomberg via Getty Images

If everything goes according to plan, the Fed will implement the first rate hike in three years in more than two months. Policymakers believe this is necessary, and the market and the economy are reluctantly accepting it.

The last time the Fed raised interest rates was at the end of 2018. This was part of the “normalization” process, which took place during the recession of the longest economic expansion in U.S. history.

Only seven months later, the central bank had to retreat as the expansion looked increasingly fragile. Eight months after the first rate cut in July 2019, the Fed was forced to lower its benchmark borrowing rate all the way to zero as the country faced a pandemic that suddenly plunged the global economy into shocking chaos.

Therefore, as officials prepare to return to a more traditional monetary policy, Wall Street is paying close attention. The first trading day of the new year shows that the market is willing to continue to push higher, amidst the volatility it has embraced since the Fed stated its policy shift a month ago.

Jim Paulsen, chief investment strategist at Leuthold Group, said: “Historically, the Federal Reserve has usually adopted multiple tightening policies before it will cause trouble to the economy and the market.”

Paulson expects the market to raise interest rates for the first time-possibly at the March 15-16 meeting-without much fanfare, as it has been fully communicated and will still only raise the benchmark overnight rate to 0.25 The range of%-0.5%.

Paulson said: “We have developed this attitude towards the Fed based on the economic growth rate of 2% per year over the past few decades.” “In a 2% stagnant economic world, if the Fed even considers tightening it , It would be harmful. But we don’t live in that world anymore.”

At the December meeting, Fed officials planned to raise interest rates two more 25 basis points before the end of the year. A basis point is equal to one hundredth of a percentage point.

According to the Chicago Mercantile Exchange’s FedWatch, the current pricing of the federal funds futures market indicates that the probability of a rate hike in March is about 60%, and the rate-setting Federal Open Market Committee’s probability of a rate hike by the end of 2022 is 61%. tool.

Those subsequent rate hikes are where the Fed might see some rebound.

The Fed is raising interest rates in response to inflationary pressures that are operating at the fastest pace in nearly 40 years. Chairman Jerome Powell (Jerome Powell) and most other policy makers insisted that prices will fall back soon for most of 2021, but at the end of the year admitted that the trend was no longer “temporary.”

Design landing

Mohamed El-Erian, Allianz’s chief economic adviser and chairman of Gramercy Fund Management, said that whether the Fed can plan an “orderly rate cut” will determine the market’s response to interest rate hikes.

In this case, “the Fed did just right, the demand eased slightly, and the supply side responded. This is a bit like Goldilocks’ adjustment,” he said on CNBC’s “Squawk Box” on Monday.

However, he said that the danger is that inflation persists and its rise even exceeds the Fed’s expectations, prompting a more aggressive response.

“Pain already exists, so they had to pursue a large-scale chase, the question is when did they lose their courage,” Erian added.

Market veterans are paying attention to bond yields, which are expected to show high-level clues about the Fed’s intentions. Despite interest rate hike expectations, the yield has remained basically under control, but Paulson said that he expects a reaction this year that may eventually increase the yield on the benchmark 10-year US Treasury bond to about 2%.

At the same time, El-Erian said that even if the market encounters some resistance, he expects the economy to perform quite well in 2022. Similarly, Paulson said that the economy is strong enough to withstand interest rate hikes, which will increase lending rates for a wide range of consumer goods. However, he said that as interest rates continue to rise, he expects an adjustment in the second half of the year.

But Lisa Shawright, chief investment officer of Morgan Stanley Wealth Management, said that she believes that market turbulence will become more apparent even if the economy grows.

The market is moving away from “the long-term decline in real interest rates, which makes
The stocks get rid of the shackles of economic fundamentals and their P/E ratios will expand,” Shalette said in a report to clients.

“Now that the federal funds rate decline period that began in early 2019 is coming to an end, real interest rates should rise from historically negative lows. This shift may trigger volatility and prompt changes in market leadership,” she added.

Later this week, when the minutes of the December FOMC meeting will be released on Wednesday, investors will have a closer look at the Fed’s thinking. The market is particularly interested not only in the decision to raise interest rates and reduce asset purchases, but also when the central bank will begin to reduce its balance sheet.

Even if the Fed intends to completely stop buying in the spring, it will continue to reinvest its current holdings, which will keep its balance sheet near the current level of $8.8 trillion.

Citigroup economist Andrew Hollenhorst predicts that the balance sheet reduction will begin in the first quarter of 2023.

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