What worries stock markets as soon as the Fed meets?

With high inflation squeezing consumers and businesses, the Fed is expected to signal that it will dramatically reverse its benchmark short-term interest rate in March from ultra-low-rate policies imposed during the pandemic downturn. To further strengthen credit, the Fed also plans to phase out its monthly bond purchases in March. And later this year, it could begin to deplete its vast reserves of Treasury and mortgage bonds.

Investors fear there is more to come. Some on Wall Street worry that the Fed could signal an upcoming half-point hike in its key rate on Wednesday. There is also concern that at a news conference, Fed Chairman Jerome Powell may suggest the central bank hikes four times this year to more than economists expect.

Another wild card — especially for Wall Street — is the Fed’s bond holdings. As recently as September, those holdings were increasing by $120 billion a month. Bond purchases, which the Fed financed by making money, were intended to lower long-term rates for borrowing and spending. Many investors saw bond purchases as helping the stock market profit by injecting cash into the financial system.

Earlier this month, minutes from the Fed’s December meeting revealed that the central bank was considering reducing its bond holdings, replacing not maturing bonds – more than eliminating purchases. aggressive move. Analysts are now predicting that the Fed may begin reducing its stake in early July, much sooner than had been expected a few months ago.

The impact of reducing the Fed’s bond stockpile is not well known. But the last time the Fed raised rates and slashed its balance sheet simultaneously was in 2018. The S&P 500 stock index fell 20% in three months.

If, as expected, the Fed raises its key rate by a quarter-point in March, it will raise the rate to a range of 0.25% to 0.5% near zero. The Fed’s moves are likely to make a wide range of borrowings — from mortgages and credit cards to auto loans and corporate credit — more expensive. Those high borrowing costs can, in turn, slow spending and undermine corporate profits. The most serious risk is that the Fed’s abandonment of low rates, which have nourished the economy and financial markets for years, could trigger another recession.

Those concerns have sent stock prices fluctuating wildly. The Dow Jones average fell more than 1,000 points during Monday’s trading session before recovering and ending with modest gains. The S&P 500 closed down 1.2% on Tuesday. Steady declines since the start of the year have left the S&P down about 10% — the level that investors define as “correcting.”

Economists have estimated that when the Fed starts allowing some of its $8.8 trillion bond holdings to roll off its balance sheet, it will do so at a pace of $100 billion per month. By not replacing certain securities, the Fed actually reduces demand for Treasuries. This increases their yields and makes it more expensive to borrow.

Yet some analysts say they’re not sure how big of an impact that will have on interest rates or how much the Fed will rely on slashing its balance sheet to influence interest rates.

“There’s a lot of uncertainty about what to expect,” said Michael Hanson, global economist at JPMorgan Chase.

Gennady Goldberg, US rates strategist at TD Securities, said Wall Street is also troubled by a sharp jump in the inflation-adjusted interest rate on the 10-year Treasury. The rate has risen by just one-half percent this month, an unusually sharp increase.

Which means Powell will face a delicate and even risky balancing act at his news conference on Wednesday.

“It’s a threading-the-needle story. They want to continue to sound hawkish — just not sharp enough to create excessive market volatility,” Goldberg said.

If the stock market is engulfed by more chaotic declines, economists say, the Fed may decide to delay some of its credit-tightening plans. However, a slight fall in share prices will not affect its plans.

“The Fed doesn’t mind looking at a reassessment of risk here at all, but wants to look at it in a systematic way,” said Ellen Gaske, chief economist at PGIM Fixed Income, global asset manager.

Some economists have expressed concern that the Fed is already moving too late to tackle high inflation. Others say they worry the Fed may be acting too aggressively. He argues that multiple rate hikes would risk a recession and would in no case slow down inflation. In this view, higher prices mostly reflect poor supply chains that the Fed is powerless to cure by raising rates.

This week’s Fed meeting comes against a backdrop of not only high inflation – consumer prices have risen 7% over the past year, the fastest pace in nearly four decades – but also an economy that is vulnerable to COVID-19 infections. Another wave is in the grip.

Powell has admitted that he failed to predict the persistence of high inflation, expressing a longstanding belief that it would prove to be temporary. Inflation growth has extended beyond sectors that were affected by supply constraints – for example, for apartment rents – which suggests it can tolerate even after goods and parts flow more freely.