What might deflect Fed from its 2022 interest rate path?

Undeterred by the emergence of Omicron, the Federal Reserve (Fed) has continued on the hawkish tack signalled by chair Powell at his recent Congressional testimony.

The US central bank has announced a more rapid tapering of asset purchases. It also signalled three rate increases for next year through its projections - the famous dot plot. On this basis the Fed would complete the taper and end asset purchases in March and then raise rates in June. Rates would then rise further in September and December.

Markets are pricing a risk of an earlier lift-off in rates.

The move reflects the Fed’s confidence in the recovery alongside a run of high inflation prints which means inflation objectives have been met. The lift-off in rates is now conditional on meeting maximum employment objectives.

These look to be on track given the strength of job openings in the economy and the evidence of a shortage of workers. In his press conference Powell noted the fall in the labour participation rate since Covid was proving more persistent than expected and that the economy was not returning to its pre-Covid state. An increase in people retiring seems to have played a role here.

The turn in the US liquidity cycle is clearly upon us, but what might deflect the Fed from its intended path? The immediate risk is Omicron and a worse-than-expected outcome where restrictions have to be re-imposed. This eventuality would call rate hikes into question.

At this stage the expectation is that the US will have sufficient resilience to be able to withstand the Omicron wave as a consequence of the vaccination programme. The experience in Europe, however, is cautionary.

Although generally milder, the scale of infection with Omicron can put pressure on hospital capacity even with a lower rate of serious cases. Generalising about the US in this respect is difficult as decisions are made on a state by state basis, but it could be a factor in the New Year.

The other factor would be the outlook for the economy and the consumer. The latest retail sales numbers disappointed. Although consumption remains robust, the forecast is very dependent on households using their pent up savings as real incomes are being squeezed by the acceleration in inflation.

Our growth forecasts are lower than those of the Fed for this reason. We see fewer rate hikes as a consequence, with two rather than three next year. That’s an uncertainty that could be exacerbated by Omicron.