The Fed’s Big Dilemma

Curt Long

In 2000, former Bank of England Governor Mervyn King acknowledged what many had long suspected: central bankers aspire to be boring. Their aims are stability and predictability, their world rife with anxious deliberations over quarter-point interest rate adjustments. In such a staid profession, what happened over the final months of 2021 qualifies as dramatic pyrotechnics. As of September, the Federal Open Market Committee (FOMC) was still holding the inflation hawks at arms’ length, with half of its members expecting rates to remain at zero through 2022. But in the weeks that followed, inflation readings remained stubbornly elevated, a new read on wage growth was higher than expected, and the pivot was on. By December, the median committee member was calling for three rate hikes, and market participants were expecting four or even five. But while inflation was the catalyst for the pivot, it will not be what determines the Fed’s rate policy in 2022. That honor goes to the yield curve.

The yield curve, approximated here as the spread between long-term (10-year) and short-term (3-month) Treasury rates, played a prominent role in the last tightening cycle. A succession of rate hikes in 2017 and 2018 was premised on the expectation that long-term rates would soon reflate, thus avoiding an inversion of the curve of the types which has historically preceded recessions. However, a rise in long-term rates failed to materialize, and the Fed’s actions led to a steady compression in spreads.

Minutes from the FOMC’s meetings show that the yield curve was a chief concern in 2018 when the 10-year/3-month spread shrunk to just over 100 basis points. By the time the Fed completed its last hike in December of that year, the spread was less than 50 basis points. The Fed quickly reversed course, emphasizing a more patient approach. By the middle of 2019, the curve inverted and the Fed was forced to cut rates.

While the FOMC is clearly intent on reducing policy accommodation in 2022, it has several options. Namely, it can raise rates or reduce the size of its balance sheet. The former will target short-term rates while the latter is believed to impact longer-term rates. But while rate hikes have a definite impact on short-term rates, the effects of reducing the balance sheet are more unclear. In the event that spreads decline, the committee is likely to put rate hikes on pause and focus on the balance sheet. But that process is not at all certain to achieve a timely increase in long-term rates. It is also notable that the FOMC is entering this tightening cycle at a time when spreads are lower than they were prior to liftoff in the last cycle.

The pandemic packed an incredible amount of volatility into a very short space of time. In the process, it made inflation a topic of conversation at every dinner table and thrust central bankers into an uncomfortable spotlight. But regardless of the Fed’s intentions, the speed of policy normalization will depend largely on the space afforded by long-term rates. In the event that rates prove uncooperative, the policy normalization process is likely to be a longer one than markets are expecting, and Fed officials will be a lot more interesting than they would prefer.