Progress towards (substantial) progress
The Federal Open Market Committee (FOMC) voted to maintain the current Federal funds target rate at a range of 0.00%–0.25% and maintained the interest rate paid on excess reserves and the overnight reverse repurchases agreement rate at 0.15% and 0.05%, respectively, in order to support smooth functioning in short term funding markets. The committee also established permanent domestic and foreign repurchase-agreement facilities, which will act as backstops in short-term funding markets.
The statement language was largely balanced in reflecting the committee’s outlook, although did signal tapering could begin later this year. It highlighted the continued improvement in economic conditions due to progress on vaccinations, but noted risks to the outlook still remain, largely reflecting the rise in cases over the past few weeks in unvaccinated communities. Moreover, while recent inflation readings have far exceeded expectations, the committee still cites these higher prints as being driven by transitory factors like supply-chain bottlenecks impacting car prices and higher energy and commodity costs.
Perhaps the most notable change pertained to the language around asset purchases, and the degree to which “substantial further progress” has been achieved to warrant a reduction in its current pace of accommodation. The committee stated that, since December—when the Federal Reserve (Fed) committed to its current pace of USD 120billion / month. in quantitative easing (QE)—the economy “has made progress” towards its goals, falling short of citing ‘substantial’. We view this as a meaningful shift in the Fed’s communication and now believe the Fed will announce its tapering plan at its September meeting, and begin to taper the pace of its purchases in December.
While Fed Chairman Jerome Powell’s comments during the press conference did not expand on the exact timing, pace and composition of tapering, he did mention that a reduction in the pace of mortgage-backed securities (MBS) purchases prior to reducing Treasury purchases as highly unlikely. However, a more aggressive reduction in MBS purchases when tapering begins may be appropriate. It should be emphasized that while the Fed believes its current stance is appropriate in balancing risks to the outlook, it’s clear the committee recognizes a growing list of reasons as to why the pace of accommodation should be reduced in the quarters ahead:
- home prices have risen substantially year-over-year aided by low mortgage rates and low inventory;
- growth and inflation are expected to run well above-trend through 2022;
- labor markets should improve markedly as federal unemployment assistance expires and rising wages attract citizens back to work; and,
- growing liquidity as a result of QE continue to cause pressures in short-term funding markets.
With that said, the delta variant poses a significant risk to unvaccinated persons and its persistence could lead to a slowing in the economy if lockdowns are reimposed or consumer behavior changes. While this isn’t our base case, the fall in yields over the last few months may be a result of bond investors assigning a higher probability to these outcomes, and technical factors causing demand to outpace supply. Moreover, market-based inflation expectations may be underappreciating the “stickiness” of inflation over the medium term, all of which are causing steady demand for duration and could keep yields stubbornly low in the months ahead. However, we expect nominal yields to realign with fundamentals and for technical factors to normalize through year-end, allowing bond yields to grind higher.
Overall, it is clear tapering is on the committee’s radar as the economy approaches the Fed’s assessment of substantial further progress. Importantly, yesterday’s meeting strongly reflects the committee’s view that fiscal support and continued vaccination efforts will sustain strong growth and strengthen the recovery in the labor market, both of which should support risk assets and higher interest rates.