The Fed is likely to indicate a March interest rate increase and that additional policy tightening is on the horizon.

• The Federal Reserve is predicted to announce at its upcoming meeting that it intends to increase interest rates in March and may also implement additional policy tightening measures.
• The Fed's policy statement, which is expected to be released Wednesday afternoon after a two-day meeting, will demonstrate its commitment to combating inflation.
• One strategist of the stock market's correction stated, "I believe they won't be scared by this," implying that the market correction wouldn't affect them. They added, "They must tighten financial conditions to better control inflation."

The Federal Reserve is predicted to announce at its upcoming meeting that it will increase interest rates as early as March and may implement additional policy tightening measures, marking a shift from the easy policies implemented to combat the pandemic.

The Fed will commence a two-day meeting on Tuesday, and on Wednesday afternoon, it is anticipated that the central bank will release a statement indicating its determination to combat inflation. Amidst a volatile stock market, Fed officials are expected to declare their readiness to increase the fed funds rate from zero as early as March.

Mark Cabana, head of U.S. short rate strategy at Bank of America, stated that they do not anticipate the Fed to sound dovish. According to him, the bond market is responding to the decline in equities and geopolitical tensions, which may cause the Fed to appear less hawkish than expected. However, he believes that the Fed will not correct the market's pricing of four rate hikes this year.

Inflation has emerged as a major challenge for the Fed, which has been grappling with it for the first time in decades following two years of easy monetary policies aimed at mitigating the economic and financial consequences of the pandemic. The consumer price index in December recorded a 7% increase, the highest since 1982.

The Fed could potentially indicate its first rate hike since 2018 at the next meeting, which is scheduled for March, as Cabana did in 2015, a month before its first rate hike following the financial crisis.

The Fed's job has become more challenging due to the stock market sell-off, which saw the S&P 500 dip into correction territory on Monday, down 10% from its record close. The market reversal was due to the pandemic continuing and Russia's threat of military action against Ukraine.

Diane Swonk, chief economist at Grant Thornton, stated that the only message they can give at this time is that they will respond as conditions warrant, as they are dealing with inflation and financial conditions are too loose.

As usual, Powell will address the media following the Fed's 2 p.m. ET statement on Wednesday, and his tone is predicted to be hawkish.

Cabana stated that he believes the Fed will declare every meeting live and use every tool to tackle inflation, which is still a problem despite the 10% decrease. He believes they won't be scared by this and need to tighten financial conditions to better manage inflation. Cabana also stated that he doesn't think the Fed will be taken aback by this or that the economy will collapse.

Other policy tightening

Central bank officials discussed paring back their nearly $9 trillion balance sheet at their December meeting, and some strategists expect the wind-down to begin in June or even as early as May.

The balance sheet size has been mainly due to the central bank's asset purchase program, which will end in March. The Fed has been purchasing $120 billion of Treasury and mortgages securities monthly but has been gradually reducing the amount.

After the program ends, Fed officials will examine ways to reduce the balance sheet. Currently, the Fed replaces maturing securities with market purchases. However, it may alter this operation and make other changes, such as adjusting the duration of securities it holds.

Swonk stated that the inconsistency of discussing reducing the balance sheet while still adding to it could lead to dissent at the upcoming meeting. She expects at least one Fed member, such as St. Louis Fed President James Bullard, to advocate for ending the purchases immediately.

The Fed is considering how aggressive to be with rate hikes, with some market experts predicting a half-percentage-point hike in March, while the consensus is for a quarter-point hike.

The Fed's decision to raise rates while simultaneously moving on the balance sheet would accelerate the pace of tightening. Swonk stated that each $500 billion on the balance sheet is equivalent to 25 basis points of tightening, with one basis point equal to 0.01%.

She stated that they could easily go faster and take it down by $100 billion a month.

Market reaction

The Fed's move towards tighter policy is expected to cause 70% to 80% of the sell-off in stocks, according to Cabana. He added that investors are surprised by the Fed's discussion of shrinking the balance sheet.

It was evident to me that this market was overly reliant on the Fed's 'put' and the belief that the Fed would always protect them," he stated. "The idea that the Fed could harm the market was inconceivable.

According to Barry Knapp, head of research at Ironsides Macroeconomics, the decline in the stock market was expected and the 11% drop in the S&P 500 as of Monday was in line with the average decline following Fed tightening moves.

Since the conclusion of the first quantitative easing program following the financial crisis, he stated that there were eight instances from 2010 to 2018, with an average decline of 11%.

We should remain stable here as there is not much that Fed Chair Jerome Powell can say to worsen the situation. The possibility of starting balance sheet reduction is being considered. The real doves agree that we must begin. Inflation is now a concern, but the market will stabilize as the growth outlook remains positive.

Rent and housing costs, which are predicted to increase, are one of the more concerning aspects of inflation, according to Knapp. He stated that if the Fed decided to remove mortgage-backed securities from its portfolio, it could help slow inflation in its entirety.

To tighten financial conditions and slow inflation, the housing market is the primary contributor in 2022, and the increase in housing prices and rental prices will continue to rise.