The Hawkish Fed signals that it may be necessary to raise interest rates earlier to fight inflation

WASHINGTON, Jan. 5 (Reuters) – A “very tight” labor market and unabated inflation may require the Federal Reserve to raise interest rates faster than expected and begin reducing its overall asset portfolio as another brake on the economy, US Federal Reserve policy makers said in their meeting last month.

In a document released on Wednesday, which the markets perceived as decidedly hawkish, the minutes of the political meeting on 14-15. December, that Fed officials are uniformly concerned about the pace of price increases that promised to continue, along with global supply bottlenecks “well into” 2022.

These concerns, at least from mid-December, even seemed to offset the risks potentially posed by the fast-growing Omicron variant of coronavirus, which some Fed officials consider likely to increase inflationary pressures, but not “fundamentally change the path of economic recovery in the United States.”

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“Participants generally noted that given their individual outlook for the economy, labor market and inflation, it may be justified to raise the federal funds rate faster or at a faster pace than participants had previously expected. Some participants also noted that it could “it would be appropriate to start reducing the size of the Federal Reserve’s balance sheet relatively soon after raising federal funds’ interest rates,” the minutes state.

The language showed the depth of the consensus that has emerged in the Fed in recent weeks on the need to move towards high inflation – not just by raising borrowing costs, but by trading with another lever and reducing the central bank’s holdings of government bonds and mortgages. -supported securities. The Fed has about $ 8.8 trillion in its balance sheet, much of it accumulated during the coronavirus pandemic to keep financial markets stable and keep long-term interest rates down.

The markets took note quickly.

The likelihood that the Fed would raise interest rates in March for the first time since the onset of the pandemic rose to more than 70%, as tracked by CME Group’s FedWatch tool.

That, plus the prospect of the Fed reducing its presence in long-term bond markets, pushed US 10-year government yields to its strongest level since April 2021.

US stocks fell with the S&P 500 (.SPX) the index fell about 1.6% as the reading of last month’s meeting showed perhaps even more conviction than investors had expected among Fed politicians to tackle inflation. Yields on 2-year government bonds, the most sensitive maturity of the Fed’s political expectations, shot to their highest level since March 2020, when the pandemic economic crisis was unfolding.

“This is news. It’s more hawkish than expected,” said David Carter, chief investment officer at Lenox Wealth Advisors in New York.

MAXIMUM EMPLOYMENT

The minutes contained more details about the Fed’s abrupt shift in policy last month, taken to counter inflation of more than double the central bank’s target of 2%.

Reuters graphics

Along with outlining their inflation concerns, officials said that even with the U.S. labor market exceeding 3 million jobs below its pre-pandemic peak, the economy was rapidly closing in on what could be considered maximum employment, given pensions and other departures from the labor market caused by the health crisis.

“Participants pointed to a number of signs that the U.S. labor market was very tight, including an almost record-high number of layoffs and vacancies as well as a remarkable increase in wage growth,” the minutes read. “Many participants estimated that if the current pace of improvement continued, the labor markets would quickly approach maximum employment.”

Politicians agreed in December to speed up the end of their pandemic-era bond buy-back program and issued forecasts expecting interest rate hikes of three-quarter percentage points over 2022. The Fed’s benchmark day-to-day rate is currently set close to zero.

The December meeting was held as the number of cases of coronavirus had started to increase due to the spread of the Omicron variant.

Infections have exploded since then, and there have been no comments yet from senior Fed officials to indicate whether the changed health situation has changed their view of appropriate monetary policy.

Fed Chairman Jerome Powell will appear before the Senate Banking Committee next week for a hearing on his nomination for another four-year term as head of the central bank, and will likely update his views on the economy at that time.

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Reporting by Howard Schneider Further reporting by Stephen Culp and Jamie McGeever Editing by Paul Simao

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