The Federal Reserve will announce at its meeting this week a scaling back of its enormous pandemic-related stimulus programme amid uncertainty over persistent inflationary pressures and whether the US central bank will need to raise interest rates sooner than expected.
Members of the Federal Open Market Committee and other Fed officials have for months engaged in an extensive debate over the appropriate moment to begin reducing or “tapering” the $120 billion (€103 billion) monthly asset-purchase programme.
The scheme was put in place last year to address dysfunctional trading conditions in the $22 trillion US government bond market and to support the economy in the face of one of the sharpest contractions in history.
The discussions are set to culminate on Wednesday, when the Fed is expected to declare victory on achieving “substantial further progress” towards dual goals of maximum employment and inflation that averages 2 per cent, and unveil plans to shrink its footprint in financial markets.
“The taper is a ‘mission accomplished’ moment,” said Brian Nick, chief investment strategist at Nuveen and a former staffer at the New York branch of the Fed. “The economy doesn’t need historically accommodative amounts of liquidity and historically easy financial conditions, but now the question is: at what point do we need to slow [things] down?”
Fed officials have already hinted at the details of the upcoming policy adjustments, including spelling out in minutes from their September policy meeting the possible scale of the reduction, in a bid to limit any adverse financial market reaction to the announcement.
The record, published in October, showed support for the Fed to pare its Treasury bond buys by $10 billion each month and its agency mortgage-backed security purchases by $5 billion, beginning as early as mid-November. That would mean that the stimulus programme could end in June next year.
What has complicated the central bank’s position heading into this week’s meeting, however, is a sharp shift in market expectations about when the Fed will raise interest rates from today’s near-zero levels.
Short-term borrowing costs have also surged, with the two-year Treasury yield now hovering around its highest level since before the pandemic, at roughly 0.5 per cent. At the beginning of October it traded closer to 0.3 per cent.
Jay Powell, Fed chair, has long sought to delink the start of tapering from the onset of higher policy rates – a view now being challenged as investors pile into bets that the Fed will be compelled to move swiftly soon after its asset purchases cease to tighten policy aggressively in the face of uncomfortably high inflation.
Eurodollar futures, a closely tracked measure of interest rate expectations, now indicate that the Fed will initiate “lift-off” around the time the bond-buying programme wraps up in June.
Goldman Sachs on Friday said an adjustment could come in July 2022, a full year earlier than its initial forecast. The bank’s economists see another increase in November, with two rate rises each subsequent year.
That differs from the individual projections published by the Fed in September, which suggest no consensus among officials on a 2022 move just yet, but at least three rate rises before the end of 2023.
Ellen Zentner, chief US economist at Morgan Stanley, expects Powell on Wednesday to push back on what she said was a move “too far forward too fast” by markets when it came to the Fed’s timeline for lift-off.
“There is a reciprocity between the Fed and financial markets,” she said. “If the market gets it wrong, the Fed has a job to do . . . [but] when the Fed lets it ride, I take it as the Fed saying: ‘You’ve not got it wrong.’”
While economists do not anticipate that the Fed will endorse the path forward for interest rates now priced in by financial markets, they do expect some adjustment to the way in which the central bank characterises inflation, which is running at multi-decade highs, according to some metrics. Without such amendments, Ms Zentner said the Fed risked appearing “tone deaf”.
Recent policy statements have deemed inflation “elevated” but “largely reflecting transitory factors”.
Michael Feroli, chief US economist at JPMorgan, said the Fed could swap “largely” with “partly” to acknowledge that price pressures were lasting longer than expected and have begun to bubble up in sectors beyond those most impacted by the pandemic. Aneta Markowska at Jefferies speculated whether the Fed would drop “transitory” altogether.
Others believe that the Fed will nod to supply-chain constraints and shortages as risks to the economic outlook to bring its official assessment more in line with recent comments from Powell and other top policymakers.
"The big unknown is: when does the shock from the pandemic start to reverse more forcefully and how long do these supply bottlenecks stay around?" said Michael Gapen, chief US economist at Barclays.
Also looming over this week’s meeting are continuing discussions about Powell’s fate at the Fed, given that his term expires in February. The Biden administration has not yet announced whether it will renominate the sitting chair as is broadly expected or instead heed calls from more progressive Democrats and put forward another candidate, such as governor Lael Brainard.
“It’ll keep Powell more cautious and methodical and not seek to rock the boat and make big shifts in policy right now,” said Julia Coronado, a former Fed economist now at MacroPolicy Perspectives. – Copyright The Financial Times Limited 2021