The Fed confirms the start of normalization

Yesterday, January 26, the Fed Open Market Committee (FOMC) released its first monetary policy announcement of the year, keeping the interest rate unchanged, in line with market expectations. .

However, the market’s attention was focused on the content of the statement and the press conference, to seek greater clarity on the critical path of the monetary policy normalization process.

Specifically, the market was very attentive to the confirmation of the first increase in the financing rate for the March meeting and was looking for clues on the path of increases for the rest of the year.

The specialists were also very vigilant for possible signals about how and when the process of withdrawing liquidity and reducing the Fed’s balance sheet will begin. As we have highlighted in this space, this last point is the most relevant for the markets after the Fed will increase the size of its balance sheet from 4 to 9 billion dollars from March 2020 to date.

The Fed statement made some important changes compared to the December meeting.

The most important one was the confirmation that he considered it appropriate to increase the financing rate in the short term. The central argument behind this statement is based on the explicit recognition that the goal of bringing the labor market to full employment has been achieved and that inflation is above the Fed’s target.

Similarly, the Fed’s message makes it clear that inflation levels were higher and more persistent than expected just a few months ago. The statement, like the one of December, set aside reports of the transient nature of inflation and made an explicit acknowledgment that the high levels of inflation are due to imbalances between supply and demand related to the economic reopening and the aftermath of the pandemic.

In his intervention with the press, the chairman of the Fed, Jay Powell, mentioned that there is a risk that inflation will not fall to its pre-pandemic level and that the rise in prices may even accelerate.

In this context, the Fed removed the reference from its statement to the need to continue to take measures to support the economy to mitigate the extraordinary effects of the pandemic to prioritize the control of inflation.

As for the future trajectory of the funding rate, there were no changes with respect to the signal sent in December expecting three increases for this 2022. However, the market has already discounted four increases and some observers think it could be more.

On the critical issue of balance sheet reduction, the Fed accompanied its press release with a separate one-page document outlining the principles of such a process. Although the document does not specify specific dates or amounts, it does state that the balance reduction plan will not start until the process of increasing the funding rate has begun.

This implies that the Fed could start withdrawing liquidity as soon as March if the inflationary trajectory continues to worsen. However, the Fed was very careful to emphasize that the process of withdrawing liquidity will be done in a prudent and predictable manner, and that, before it starts selling assets, it will make gradual adjustments in the amount of reinvestment of amortizations of financial instruments that are in your balance sheet today.

The announcement was not well received by the markets, which wiped out their intraday gains and closed in negative territory after the announcement.

As we have already discussed in this space, after years of almost infinite liquidity, the biggest concern of the markets is how aggressive the Fed’s balance sheet reduction process will be in an environment of persistent inflation. The Fed has the difficult task of balancing the withdrawal of liquidity to fight inflation without causing a disorderly adjustment in the markets.

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Joaquin Lopez-Doriga Ostolaza

Socio Director of EP Capital, SC

Without Borders

Joaquín López-Dóriga Ostolaza is the managing partner of EP Capital, SC, a consulting company specializing in mergers and acquisitions established in 2009.

He is a graduate of the Bachelor of Economics from the Universidad Iberoamericana, where he graduated with honors and the highest average of his generation. He holds a master’s degree in economics from the London School of Economics, where he was honored with the British Council Chevening Scholarship Award.

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