MNI STATE OF PLAY: Fed To Begin Tightening Amid Surging Prices

The Federal Reserve on Wednesday is set to raise interest rates for the first time since the pandemic and signal further increases to combat high inflation that's proven more persistent than officials anticipated.

Having pinned the fed funds rate near zero for the past two years, the FOMC is expected to nudge it into a target range of 0.25% to 0.5% and pencil in another four or five quarter-point increases for later in the year.

But officials may shy away from more explicit guidance, emphasizing that decisions are being made on a meeting-by-meeting basis amid heightened uncertainty about how the Ukraine war will evolve, former top policymakers told MNI.

"They've got to react to inflation, but the point is they can't be as aggressive. Because then you'll risk more economic weakness than you'd otherwise have," said Richard Berner, former head of Treasury's Office of Financial Research, now a NYU Stern professor.

INFLATION RISKS RISE

Even if the Fed hikes at every meeting this year, Ex-Boston Fed President Eric Rosengren worries that inflation could stay above the Fed's 2% target for years, as Russia's invasion of Ukraine and Chinese factory shutdowns exacerbate cost pressures.

Many Fed officials still view the inflation surge as temporary to a large extent, but there are signs that consumers are becoming far more sensitive to current events as gas prices hit record highs, raising the risk that inflation expectations could become unanchored.

If the inflation outlook worsens, the FOMC is prepared to make larger 50bp adjustments later in the year, taking the fed funds rate close to 2%, the lower bound of its estimated longer-run rate, former Fed staffers told MNI.

If FOMC projections this week show rates rising above neutral in the near future, it could signal more willingness to risk labor market losses to restrain the economy, they added.

QT PLAN

Fed Chair Jerome Powell may also reveal additional details in the Fed's plan to shrink its USD9 trillion balance sheet this week as discussions on QT resume.

FOMC members are coalescing around a gradualist, highly telegraphed approach involving rising caps on the reinvestment of maturing assets. They could launch QT around mid-year and the caps are likely to max out at a monthly pace above the peak QT rate of USD50 billion in 2018, former officials said.

Some Fed officials favor using active sales of longer-dated Treasuries and MBS to fight inflation, but the potential for market disruption and political optics of possible losses for the central bank could keep such a plan grounded.

"We know it's an important tool but it is a background tool," San Francisco Fed President Mary Daly said in an MNI interview.