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Fed could raise rates as soon as March

Khatija Haque - Head of Research & Chief Economist
Published Date: 18 January 2022


Recent economic data and increasingly hawkish commentary by Federal Reserve officials have led us to bring forward the start of the rate hiking cycle in the US to March, even amid the near-term downside risks to growth posed by the spread of the Omicron variant of the coronavirus in the US. 

Labour market data suggest the economy is close to maximum employment. The U3 unemployment rate fell below 4% in December, and wage growth has accelerated. The strong unemployment number came even as prime age labour force participation remains below pre-pandemic levels. With participation levels drifting amid a wave of early retirements and workers exiting the labour force, the spread of the Omicron variant in the US may act as an additional deterrent to people returning to the labour market in the near-term, which may exacerbate upward pressure on wages. The Atlanta Fed’s Wage Growth Tracker shows overall wage growth running at 4.5% y/y in December, the fastest in almost 20 years.

US unemployment almost at pre-pandemic low

Source: Bloomberg, Emirates NBD Research

Meanwhile, inflation reached 7.0% in December and is likely to remain elevated through the first half of this year.  Energy prices remain high and the spread of the Omicron variant could put further pressure on supply chains. Moreover, inflationary pressures have become more broad-based, with core CPI rising 5.5% y/y in December, up from 4.9% in November. The latest University of Michigan consumer sentiment survey will not have provided much comfort to Fed officials either – long-term inflation expectations rose to 3.1% in January, the highest in over a decade.  While we still expect both headline and core inflation to soften in H2 2022, core inflation will remain well above the Fed's 2% goal this year.

Core inflation and wage growth accelerated sharply in Q4 2021

Source: Bloomberg, Emirates NBD Research

With the Fed seemingly looking at inflation as the more meaningful risk to the US economy than Covid-19, we now expect the Fed to raise rates by 25bp at the March meeting, rather than wait until May.  We have pencilled in a further three rate hikes before the end of 2022.

There are some downside risks to this view, not least from the spread of the Omicron variant in the US which could lead to a sharper slowdown in economic activity and labour market conditions in the first quarter of 2022.  With few new restrictions likely to be imposed, and households in a relatively strong financial position on aggregate, the impact of Omicron on activity will likely be relatively short, with growth rebounding over the course of the year.

Another uncertainty is who will be appointed to the fill the three empty seats on the Fed Board this year. President Biden has nominated Sarah Raskin, Lisa Cook and Philip Jefferson.  If they prove to be more dovish than the FOMC members they replace, it could result in a slower pace of rate hikes, particularly if inflation slows as expected in the latter part of this year.

The clearest upside risk to our view is that inflation remains higher for longer in H2 2022.  Our baseline view is that base effects (particularly on energy prices) will prove disinflationary, while increased labour force participation and the resolution of supply chain issues will further curb inflation this year.  If energy prices remain elevated – due to geopolitical tensions or lack of supply in the face of robust demand – or Covid-19 policy responses continue to disrupt supply chains and deter people from returning to the job market, then the Fed may need to do more to curb inflationary pressure and inflation expectations.  Further tightening in monetary policy later this year could be in the form of balance sheet reduction in addition to more rate hikes.