Fed policy liftoff will be a ‘delicate exercise’ for Chair Powell, economist says

Greg Daco, EY-Parthenon Chief Economist, joins Yahoo Finance Live to discuss the Federal Reserve's policy decision, what to expect at Fed Chair Powell's press conference, and inflation.

Video Transcript

KARINA MITCHELL: Let's stay on all of the market action tied to the Fed and bring in our guest Greg Daco from EY Parthenon, the Chief Economist there. Thank you so much, Greg, for being here on decision day and wondering what your thoughts are. Was this the sort of policy response that the Fed needed to put out? Does it restore its credibility?

GREG DACO: Well, I think it's a policy statement that's in line with expectations. We were expecting the Fed to come out with a statement that inflation remains elevated, that the labor market is strong, that there will be disruptions in the short run from the Omicron variant, but at the same time, that the Fed has made that hawkish pivot towards a rate lift off in March, which was communicated with the soon appropriate statement, and that it will probably proceed with a total of four rate hikes this year.

Now, that will be up to Fed Chair Powell in the press conference to detail how aggressive the Fed wants to be in terms of tightening monetary policy, how many rate hikes are likely in the coming months, as well as how rapidly and how the Fed will proceed with the balance sheet runoff. I think Fed Chair Powell will likely want to stay off of details as to how much they will want to tighten monetary policy, retaining some form of policy optionality by doing so.

ADAM SHAPIRO: Do you think we'll get any kind of commitment or hint at whether it's going to be 50 basis points or just 25 basis points at the March meeting?

GREG DACO: Yeah, I don't think there will be any indication that this will be a 50 basis point rate liftoff. There's no need for that type of strong liftoff at this point. We have markets and investors that are pricing in four rate hikes this year with liftoff in March. That's in line with the statement. I think that's in line with where the Fed feels it's comfortable.

It does not need to jolt the markets further with any signs that will lift off with a 50 basis point increase. So I think there will not be any signal as such. And the Fed will want to stay fairly careful, because it has to navigate this delicate rebalancing act of monetary policy in an environment where we're starting to see financial conditions tighten. So this will be a very delicate exercise for Fed Chair Powell. I think he will want to stay off of any details as to how strongly the Fed wants to navigate its monetary policy tightening, because markets are probably well priced at this point.

ALEXIS CHRISTOFOROUS: You know, Greg, if the balance sheet rolloff is successful, do you see the Fed perhaps pulling back on how many rate hikes it might have to institute this year?

GREG DACO: There's a potential for that. We know from the Fed minutes that Fed policymakers have discussed the option of using the runoff of the balance sheet as an alternative to raising rates. But I think in the current context, the Fed is likely to proceed with an approach that is likely gradual in terms of rate increases, probably three to four rate hikes this year depending on, again, economic conditions on how inflation evolves over the coming months, whether it comes down and how fast it comes down.

And then consider the balance sheet runoff in the second half of this year with a gradual approach-- probably a cap system with redemptions gradually increasing over time. But it won't want to necessarily rush into this runoff of the balance sheet. It will likely want to take its time and retain optionality to react as economic conditions evolve.

KARINA MITCHELL: But can the Fed deliver a soft landing, do you think? Because inflation is red hot. 7% is a handle. But in parts of the country, you know, in the South and in the Midwest, it's up to 9%. The IMF has revised down growth for this year as well.

GREG DACO: Yeah, we have what we've previously described as a messy inflation environment where we have moderating growth but still persistent inflation. And that's really tricky to navigate from a Fed's perspective. We know that inflation is likely to peak around the first quarter of this year, although increasing energy prices may actually delay that peak. But we also know that economic momentum is likely to cool over the course of this year. And the labor market remains fairly hot and fairly tight.

So it's a delicate rebalancing act that we'll have to observe over the course of this year. It's always very difficult for any Fed-- any Fed policymaker to engineer a soft landing when it comes to monetary policy. So this will be a challenge. It will not be easy, and it will not be easy in an environment where we have still this COVID situation that lurks in the background and we have a number of unknowns as to how the health situation will evolve, because we know that the health situation is the most important element at this point driving economic activity.

ADAM SHAPIRO: It's a little wonky, but help us understand when we talk about rolloff-- in the real world, what does that look like when $8.8 trillion starts to fall and get-- where do we on the street actually feel it or see it?

GREG DACO: Well, the balance sheet rolloff is likely to be a fairly passive one. So essentially, the Fed will allow assets to mature, both in terms of treasuries and in terms of mortgage-backed securities. What effect that has on the real economy is largely via financial conditions. Essentially, it's via the interest rate channel where, excuse me, you start to see potential increases in long-term bonds, long-term yields.

That tends to be the direct effect on the real economy, because that, then, influences the borrowing costs for businesses, it influences the borrowing costs for potential homebuyers. So that's generally the direct channel through which you see that runoff affecting the real economy.

ALEXIS CHRISTOFOROUS: All right, Greg Daco of EY Parthenon, Chief Economist there. Thanks so much for sharing your thoughts.