Focus on taper, not rates for now
Dr. David Kelly
The Federal Open Market Committee (FOMC) voted to maintain the current Federal funds target rate at a range of 0.00%–0.25% and officially announced its plans to taper its net asset purchases by USD 15billion per month beginning in mid-November. Compositionally, the committee will reduce its purchases of U.S. Treasuries and agency mortgage-backed securities by USD 10billion and USD 5billion per month, respectively. This strategy suggests the FOMC will conclude tapering in June 2022 and begin reinvesting maturing securities in order to keep the balance sheet level.
The statement language struck a somewhat more optimistic outlook. While it acknowledged the recent slowdown in economic activity, it stated the “summer’s rise in COVID-19 cases” as contributing to the third-quarter slowdown, suggesting the delta wave will continue to recede, thereby improving the outlook. Elsewhere, the committee continues to describe inflation as transitory, but explicitly noted supply and demand imbalances related to persistent supply constraints as a driving factor for the higher inflation prints this year.
During the press conference, the Federal Reserve (Fed) Chairman Jerome Powell acknowledged the challenges this highly uncertain outlook presents policymakers. With that said, we took away a few key points from Chairman Powell’s comments:
- Tapering does not imply raising interest rates is imminent. The committee appears to be putting a bigger emphasis on reaching maximum employment next year as a necessary condition to consider rate hikes. This condition, of course, could be met, but there is still ground to cover.
- It seems increasingly clear that the committee would like to see labor force participation rates rise before rate liftoff.
- Transitory inflation does not mean “short-lived”, i.e. investors have mistakenly assigned a three- to six-month window for higher inflationary pressures to abate; but rather transitory means temporary price fluctuations that are not expected leave a permanent shift—up or down—on long-run inflation.
- Supply-side constraints are expected to last well into 2022 and the committee expects inflation should begin to normalize in the second half of next year.
Investors should not be surprised by today’s announcement. The Fed has been transparent in its communication around when the committee could begin tapering. It should be emphasized though, that tapering is not tightening, and while purchases will slow in the months ahead, the balance sheet will still expand by roughly USD 400billion from now until mid-2022 and settle at around USD 9trillion.
Lastly, we suspect employment and price conditions will be met to warrant a rate hike in 4Q22. While markets continue to be more aggressive in their expectations of rate hikes next year, we think the Fed will be much more patient in tightening policy than their developed market peers.