The March
Towards March

The U.S. economy expanded by an annualized rate of 6.9% in the fourth quarter of 2021. Underlying components like consumer spending and business investment remained solid, but rising inventories accounted for 4.9 percentage points of the increase as businesses restocked. Though encouraging, we think it may be too early to say that the inventory rebuild is a sign of an easing in supply bottlenecks.

Wages grew at the fastest pace in 21 years. The U.S. employment cost index – a quarterly measure of wages and benefits paid by employers – rose 4.0% year-on-year. With a broad range of industries facing labor shortages, we expect wage pressures to continue to broaden over time. This could keep core inflation at a higher level than pre-pandemic for some time.

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Fed Chair Powell did not blink during his January FOMC press conference and signaled that the Fed is steadily marching towards its goal of raising interest rates…presumably in March 2022. Perhaps more importantly, he did not push back against the notion that rate hikes could occur at a monthly pace and said that the “there’s a substantial amount of shrinkage in the balance sheet that must be done.” This is a vastly different path of monetary policy normalization than what markets witnessed following the Global Financial Crisis. At the time, the Fed raised interest rates for the first time in December 2015 but waited two years before starting to reduce the balance sheet. This time around, the Fed is telling investors that it will likely start a runoff of the balance sheet just two meetings after the first rate hike.

This is material change from former Fed Chair Ben Bernanke who argued that the effect of the balance sheet on broader financial conditions is uncertain and that it is not prudent to begin that process until short-term interest rates are comfortably away from their effective lower bound so that it leaves the Committee room to offset any unanticipated effects. As figure 1 shows, the combination of both rate hikes and balance sheet reduction essentially equates to more rate hikes with balance sheet reduction and four rate hikes potentially akin to tightening policy from a 0.0% policy rate to a 2.0% policy rate.

This graph shows the U.S. Fed Funds Rate vs. Wu-Xia Shadow Fed Funds Rate

Former Fed Chair Bernanke also stated that the FOMC should have a clear idea of what the ultimate size should be when communicating intentions. By using such vague statements like “there is a substantial amount of shrinkage needed”, the Fed is increasing monetary policy uncertainty by leaving it up to markets to guess what might happen. The result has been a quick de-risking by investors…particularly within the technology sector with the NASDAQ down 9.0% year-to-date.

As it stands now, the market is pricing in a 100% chance of a 25 basis point rate hike in March and a 19% chance of a 50 basis point rate hike. For the full year, a 100% chance of four rate hikes and a 93.5% chance of five rate hikes (see figure 2). Prior to the Fed meeting, the market was pricing in just four rate hikes. In terms of the balance sheet, Chair Powell has said that the committee will need another couple of meetings to firm up its plans. The last time the Fed unwound the balance sheet, it started with $10 billion a month and raised the cap by $10 billion every quarter until it reached $50 billion a month. They managed to reduce the balance sheet by $600 billion before stopping. Citi Research’s economists think that the Fed will announce its plan for runoff in June and it will start in July.

This line chart shows the number of Fed Rate Hikes expected by year-end 2022

While the current path being projected is much more aggressive than originally thought, it’s worth noting that the Fed has just proven that it can change policy quickly. Even though the Fed Chair has been jawboning investors into believing that it is taking elevated inflation very seriously, San Francisco Fed President Mary Daly said more recently that a fed funds rate of 1.25% by year’s end is quite a bit of tightening and that “you don’t want to ratchet up rates so quickly that it bridles growth too much.” Likewise, Kansas City Fed President Esther George, who is a voting member and a known hawk, said, “You always want to go gradually, in the economy. It is in no one’s interest to try to upset the economy with unexpected adjustments.” These comments may suggest an initial attempt to calm markets.

With the Fed clearly focused on its price stability mandate, it seems likely that the path of inflation will determine the path of monetary policy. While this is less than ideal with inflation categorized as a lagging economic indicator, meaning that inflation data are telling investors something that already happened versus something that will happen, it may be the best guide for the path forward. Although inflation is running hot, we find it encouraging that inflation metrics like the Atlanta Fed’s sticky consumer price index are not suggesting that inflation is as entrenched as it was in the 1970s (see figure 3). As such, we remain doubtful that the Fed will need to act as aggressively as it did during the Volcker era to choke off inflation (which in turn choked off the economic expansion). We think a clearing of supply bottlenecks could a long way towards helping the Fed reach its goal of price stability.

This line graph shows Atlanta Fed’s Measure of Flexible vs. Sticky Consumer Prices.

Citi’s Global Investment Committee (GIC) was already positioned defensively in anticipation of mid-cycle economic conditions; however, the Committee recommends remaining focused on high conviction long-term potential opportunities like global pharmaceuticals, cyber-security, and fintech while adding further to quality income-producing assets like global dividend growers. We also recommend broadening equity exposure to regions outside the United States where valuations are more reasonable and earnings-per-share revisions are trending upward. We would also remind investors that the old market adage of “As Goes January, So Goes the Year,” has been far from accurate with annual returns positive in remainder of the year the last 9 out of 10 times that returns were negative in January (see figure 4). The one exception was 2008, which was during the height of the Global Financial Crisis.

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