The Fed’s Road to Full Normalization

At the January 2022 meeting, the U.S. Federal Reserve signaled an accelerated timetable to normalize policy, but it will be a long process amid an uncertain environment.

With inflation still well above the U.S. Federal Reserve’s target and the unemployment rate now below estimates for the long-run maximum level, the Fed reiterated recent guidance following its January meeting: Officials expect to hike the policy rate in March, kicking off a series of four rate hikes in 2022. Although the Fed’s near-term rate trajectory indicates a sooner and more rapid rise in response to inflationary risks, we haven’t changed our expectation that a still-low neutral rate, larger central bank balance sheet, and generally higher economy-wide debt levels will keep the terminal level of this rate hiking cycle at or even below that achieved in 2018 (i.e., a range of 2.25%–2.5%).

Meanwhile, Fed officials signaled an earlier start to winding down the central bank’s balance sheet (a process known as quantitative tightening or QT) by releasing a list of balance sheet policy principles, which provided some high-level information about the Fed’s plan for a significant reduction in assets held. While officials didn’t provide additional details on the pace or likely start to the program, we expect it to begin around midyear (following the end of asset purchases in early March), when the fed funds rate is expected to be above 0.5%.

Accelerating the timetable

Since the previous FOMC (Federal Open Market Committee) meeting in mid-December, a surprisingly strong December employment report prompted Fed officials to once again pull forward expectations for liftoff from the current 0%–0.25% fed funds rate. The 3.9% unemployment rate is now below FOMC estimates for its long-run level (a proxy for maximum employment), and inflation has significantly overshot the Fed’s longer-term target (2% PCE, or personal consumption expenditures). Although headline inflation levels are expected to moderate this year, the strong labor market recovery and resulting pressures on wages were likely key factors behind the Fed’s plan to remove policy accommodation. We believe the Fed is targeting a more neutral stance in order to position policy for elevated inflation risks.

To this end, the Fed used the January meeting – the last meeting before expected liftoff in March – to formally signal an upcoming rate hike by amending the forward guidance section of the January FOMC statement to say it will “soon” be appropriate to raise rates. The March rate hike is likely to kick off a sequence of quarterly rate hikes and the beginning of QT later this year, given Fed Chair Jerome Powell’s comment at the press conference that it will soon be appropriate to “steadily move away” from the current highly accommodative monetary policy.