In a clear illustration of how much things can change in a year, the US Federal Reserve looks set to kick off a new era of policy tightening in 2022. That could include raising interest rates at least three times this year and possibly also, a gradual reversal of its bond buying program which it has been using in tandem with low rates and which has effectively seen the Fed double the size of its balance sheet over a period of less than two years.

Officials had originally kicked off 2021 with plans to keep interest rates at rock bottom for at least two more years and judged elevated inflation pressures as a temporary blip in a financial system recovering from a pandemic. However, inflation has skyrocketed in 2021, with consumer prices in November climbing 6.9 per cent from a year ago, the fastest pace since 1982.

For months, the Fed’s mantra has been that inflationary pressures are temporary and they would eventually subside once the US economy moves past the pandemic. However, supply pressures have led to a shortage of goods, and officials have seen a persistent gaping hole in the US labour force, with nearly 2.3 million workers still missing.

Fed chairman Jerome Powell still expects inflation to drop below three per cent in 2022. But Powell is concerned that 2021’s rate near seven per cent might cause businesses and workers to increase their expectations of future inflation, thus raising prices and wages in a self-fulling prophecy.

To this end, the minutes from December meeting of the Federal Open Market Committee which were released last Wednesday, suggested that officials were fully on board with a faster scale back of the central bank’s asset purchase program. That would give the Fed greater flexibility to raise interest rates which economists and investors now think could happen as soon as March.

Officials might then move to further cool off the economy by reducing the nearly $9 trillion balance sheet – where the bonds they bought are held. While the Fed did not put a timetable on a runoff (that’s when it shrinks holdings by allowing bonds to mature), many are estimating the tightening could happen as soon as the summer. That could help to push up longer-term interest rates, which could make borrowings for many types of purchases more expensive and further weaken demand.

Markets reacted swiftly to the news with the yield on the 10-year US Treasury notes climbing by over a quarter of a percentage since the start of the year, reaching 1.766 per cent by end of the first week. Similar moves were experienced in European sovereigns and corporate credit where yields have continued to recent rise with the uncertainties caused by the recent inflation surge. Meanwhile, growth-oriented stocks were also significantly impacted because of the erosion effect higher rates would have on future earnings.

The Fed faces trade-offs as it contemplates the path ahead. Higher interest rates could weaken a job market that is still pulling people back from the sidelines after 2020 pandemic lockdowns. But if the Fed waits too long or moves too slowly, businesses and consumers could begin to adjust their behavior to the very high inflation that has troubled the economy much of the past year. That could make it harder to bring price gains back under control – forcing more drastic, and potentially even recession-causing, rate increases down the road.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

For more information visit The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.