The Federal Reserve will hold its first meeting of the year on tomorrow and Wednesday. Despite high inflation, we don’t expect a policy move this week, as it really is too soon to tell how the latest pandemic wave has impacted the economy. However, we expect the Fed to set the table for an end to quantitative easing and a first 25-basis point rate hike at their March meeting. In addition, Chairman Powell may well shed further light on the timing and potential pace of quantitative tightening, which we now expect to begin later this year.
For markets, the Fed’s growing hawkishness is a clear warning sign of higher long-term interest rates ahead. Inflation is now running at an almost 40-year high and the Fed’s actions in recent years have clearly fueled speculative asset bubbles across financial markets. In previous tightening episodes, the Fed could well have argued that it only had the power to control short-term interest rates. However, the Fed’s balance sheet now contains $5.7 trillion in Treasuries and $2.7 trillion in mortgage-backed securities. Given the size of these assets relative to their respective markets, the Fed surely has the ability to boost long rates as much as it wants just by adjusting the pace at which it reduces its holdings.
Economic historians, in the decades to come, will likely conclude that the Federal Reserve kept long-term interest rates too low for too long after the Great Financial Crisis, thereby contributing to asset bubbles and, eventually, more general inflation. However, that being said, the Fed needs to be careful not to overdo it at this stage. The classic monetary mistake is to overreact late.
Provided the Fed can avoid this, a steady increase in long-term interest rates in a slow-but-steady economic expansion could gradually resolve the asset bubbles and relative valuation distortions that pervade financial markets today. For investors, the key will be to focus on those areas of markets, such as U.S. value stocks and international stocks, which have not been caught up in the Fed-fueled frenzy and maintain broad diversification in case something goes wrong with the Fed’s attempt to achieve a soft-landing of a pretty unbalanced economic plane.
David Kelly is chief global strategist at JPMorgan Funds. Stephanie Aliaga is a research analyst at JPMorgan Funds.