Pub. 11 2021-2022 Issue 5

We examined recent comments from the Federal Reserve and devised a few scenarios to help our members prepare for what’s next. The Federal Reserve’s Outlook The profoundly hawkish shift in tone from the Federal Reserve first appeared in their December 2021 minutes. This was evident- from the following quotes: “…it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.” “…it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate.” Shortly after the minutes were released the first week of 2022, Bloomberg’s Fed Rate Hike Probability Index moved to a 78% chance for March with a potential three additional hikes by year-end (Exhibit 1). By February, the chances for a March hike reached 100%. Combined with rising bond yields and inflation concerns, there’s no question that the Fed has embarked on the next tightening cycle. While all signs seem to point to a fast and aggressive Fed tightening, members should avoid predicting the timing and scale of the next rate cycle. Instead, ensure that your strategy prepares for several interest rate scenarios. The following are a few scenarios for consideration: Scenario No. 1 – The Next Tightening Cycle The Fed hikes rates multiple times in 2022 and begins to reduce the balance sheet. If this goes on without any material market disruption, the next rate cycle will be underway. What to expect: Institutions could see liquidity begin to decrease, loan demand increase, margins improve, and the economy move forward in a growth cycle. Don’t Predict, Prepare Scenarios to Consider for Fed Rate Hikes By Drew Simmons, Oklahoma Regional Account Manager, FHLBank Topeka Scenario No. 2 – The Fed Tests the Market The Fed’s first rate hike following the Great Recession came in December 2015, and they didn’t hike rates again until December 2016. This “hike and wait” strategy was emblematic of one of the longest economic recoveries in modern history. The Fed could find themselves in a similar strategy should the COVID Omicron variant (or others) create economic challenges such as persistent labor supply constraints, disinflation and/or geo-political risks. Exhibit 1 / Bloomberg’s Fed Rate Hike Probability Index What to expect: Institutions would experience high liquidity, low-to-moderate loan demand and tight margins as the recovery takes longer than expected. Scenario No. 3 – The Double-Dip Recession We could enter a second recession that could be exacerbated by the Fed acting too soon and failing to identify unsustainable asset bubbles. This economic recovery doesn’t fit the mold of prior recovery cycles, so we’re in uncharted territory. Stocks have done surprisingly well, reaching new highs each quarter since March 2020. There’s been plenty of talk about an unsustainable housing market as well. Any major asset bubble could trigger another recession, which would force the Fed to crank back up its accommodative coloradobankers.org 16

RkJQdWJsaXNoZXIy MTIyNDg2OA==