Our 2022 scenario for US monetary policy

In 2022, we expect the Federal Reserve (Fed) to show increasing concerns about the potential stickiness of inflation and the risk that it spills over into wages and inflation expectations. We also expect the Fed to conclude that the US labour market is much tighter than it previously believed.

The Fed’s monthly asset purchases will likely need to end faster than the June 2022 date the Fed had initially pencilled in. Recent hawkish comments from Fed chairman Jerome Powell seem to vindicate this scenario. We think the first Fed rate hike could come soon after the Fed has brought forward the end of quantitative easing – possibly in June 2022. While we think the Fed remains highly sensitive to financial markets, our central scenario is for one rate hike per quarter between June 2022 and mid-2023, i.e. five rate hikes in total.

In the long run, we think the Fed will not want to move interest rates above its 2% inflation target – in essence, inflation-adjusted Fed interest rates will stay negative for a while. We also think the Fed will be patient before shrinking its enormous balance sheet.

Structurally, we believe the Fed is in a ‘debt dominance’ monetary policy regime. In other words, we think its overarching (if unstated) priority is to prolong the business cycle and to avoid a debt-driven recession. Since such a regime means maintaining interest rates structurally low, one might wonder whether the Fed has not painted itself into a corner. There are potential hidden costs to structurally hyper-simulative monetary policies, especially the side-effects of ever-rising debt (and the harm done to ‘risk-free’ savings). But the Fed will likely continue to prioritise short-term benefits above long-term financial risks and other economic distortions.

In an alternative, more positive, scenario, the Fed could continue with QE until June 2022 and refrain from hiking rates at that point— for instance, if the coronavirus was still having sizeable repercussions on the economy and it shifted back to prioritising growth over the inflation risk.

In an alternative, more negative, scenario, there could be a sharp pick-up in the Fed’s own inflation-expectation indicators (which are very much fashioned by the bond market) leading to more aggressive monetary tightening. Such surprise tightening would be reminiscent of what the Fed did when Paul Volcker was Fed chairman in the early 1980s to restore the central bank’s inflation credibility. But we would assign a low probability to a ‘Volcker 2.0’ scenario under the current Fed chairman.