Four things Jerome Powell underlined in his Senate testimony

12 Jan 2022 , 03:42 PM

As is the norm, the publication of the minutes of the Fed meeting has been followed up by the Senate testimony of Jerome Powell, Chairperson of the Fed. This policy had set the tone for rapid tapering, early rate hikes and possibly even a winding down of the balance sheet of the Fed. Here are for important things Powell said in his testimony.

1. Era of pandemic stimulus is done and dusted

This is one of the most crucial pronouncements from Powell in his testimony to the Senate. He left no doubt that the pandemic stimulus was well and truly over. Between 2020 and 2021, the US Federal Reserve had helped to channelize trillions of dollars into the pockets of common Americans. This ensured that people could maintain their basic purchase standards so there was no popular unrest or compression in demand. That goal has been achieved.

Powell has underlined that he does not see the need to continue with the stimulus any longer. What this means is that any hopes that the US may perpetuate the stimulus package to cover the Omicron risk, are too optimistic at this point of time. The Fed would not be keen to expand its balance sheet any further even if it means that Omicron may pose a temporary threat to growth and income levels. In short, the pandemic stimulus is over and the US will now start the process of unwinding the stimulus gradually.

2. Inflation remains a major threat to the economy

There are no two opinions about inflation. In fact, in the latest Fed policy statement, the Fed has dropped the word “Transitory” from the description of inflation altogether. The last inflation number was 6.2%. For December 2021, the inflation is expected to be closer to 7.1%. That will be the highest inflation in last 40 years since the Volcker era.

While the inflation impact on purchasing power was beyond question, the Fed is more worried about the impact of sticky inflation on the US jobs market. He has underlined in his testimony that the highly accommodative policies had been in place since the onset of the pandemic. They had done the job.

However, that may not be required any longer as higher inflation was likely to threaten maximum employment going ahead. Powell also added in his testimony that the Fed would use all tools at its disposal to prevent inflation from flaring in the future. However, in a cryptic statement, Powell did remark that the Fed had little control over the overpowering commodity prices.

3. Rate hikes cold be more aggressive, says Powell

One of the most important points made by Powell in his testimony was that the rate hikes could be quicker than expected, both in terms of size and timing. For example, the Fed had started off pencilling 3 rate hikes of 25 bps this year. However, the latest estimates of Goldman Sachs is building in 4 rate hikes of 25 bps each with CME Fedwatch probability of over 50%. Even 5 rate hikes in 2022 has 23% probability, although it is tad hypothetical.

Powell has specifically made this statement considering that the retail inflation for the month of December was expected to come in sharply higher at 7.1% on Wednesday 12th January. That would make a clear case for at least 4 rate hikes in 2022, perhaps starting from March. Powell has indicated that rate hikes may start in March immediately after the $120 billion monthly purchase program is fully tapered.

4. Fed’s $9 trillion balance sheet to start winding down this year

This is different from the taper. The taper that completes in March this year, will only put an end to the fresh purchase of government and mortgage bonds. However, there is an existing balance sheet of the Fed that has bloated substantially in the last couple of years. The first stimulus of 2008 after the financial crisis, ended up expanding the Fed balance sheet to $5 billion.

While the winding down did start in 2016, the process had to be abruptly called off in 2019 amidst the COVID scare. Between 2019 and 2021, the Fed balance sheet had expanded from $4 trillion to $9 trillion. The Powell testimony underlines that, among other things, the Fed would also commence unwinding its $9 trillion bond portfolio in phased, starting 2022.

5. What explains this sudden pivot in Fed approach?

If you compare the Fed testimony of Powell in Jan-22 with earlier testimonies of 2021, there are several shifts. Firstly, the inflation is no longer being seen as transitory although there is consensus on inflation being supply side driven. Secondly, there has been a shift from calibrated rate hikes to rapid rate hikes. There has also been a shift from back ending of rate hikes to front ending of rate hikes.

Thirdly, growth push is no longer the central policy theme of the Fed. With this Fed testimony, it has fully shifted to normalization. Lastly, the biggest shift is that the Fed has tacitly accepted that it has done everything in its power to boost economy and such largesse is neither feasible nor prudent to continue That, possibly, sums of the Powell testimony.