The Federal Reserve announced on Wednesday that later this month it would start paring back its pandemic-era monetary accommodation even as it held its policy rate between zero and 25 basis points.
This policy step creates the condition for the inevitable normalization of the Fed’s monetary policies.
This policy step, announced after the two-day meeting of the Federal Open Market Committee, creates the condition for the inevitable normalization of the Fed’s monetary policies.
But the pricing in of five rate hikes by the market through the end of 2023 looks a bit premature in our estimation.
The central bank announced that it would pare back its $120 billion a month in asset purchases by $15 billion a month—$10 billion in Treasury bonds and $5 billion in mortgage-backed securities.
That would put the Fed on pace to end its asset purchases next June or July. In its statement, the central bank retained the flexibility to adjust the pace of its reduction in purchases based on prevailing economic conditions.
Talk like a hawk, act like a dove
Federal Reserve Chairman Jerome Powell took the opportunity during his news conference to re-establish a high bar for increasing the policy rate, noting that the central bank would impose stringent conditions for such increases.
Powell, along with the European Central Banks’s Christine Lagarde and the Reserve Bank of Australia, which struck an unexpectedly dovish tone this week, would appear to have attempted to reset market expectations around the eventual rate hikes.
Until then, policymakers, market participants and firm managers should anticipate that global central bankers will talk like hawks to influence the yield curves and inflation expectations, all while acting like doves and maintaining accommodative policies.
Over the next year, watch what central banks do as much as what they say.
The growth paragraph in the Fed’s statement released on Wednesday reflected the robust pace of economic expansion on a nominal basis through the end of the third quarter.
It pointed to the pandemic as the primary cause for the slowing in growth during the summer and made the case that progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation.
We still expect no hike in the policy rate until after the midterm elections next November, which would most likely imply a rate increase in the first quarter of 2023.
But should the supply chain inflation causing consternation among central bankers not ease, the Fed would be put in the unenviable position of pulling forward rate hikes into the second half of next year, just after it wraps up its tapering operations.
Inflation communications
The Fed altered the language on inflation it has used during the pandemic to acknowledge the price increases related to supply chain issues.
Specifically, the central bank changed its language to say: “Inflation is elevated, largely reflecting factors that are expected to be transitory. Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.”
The Fed mentioned supply challenges In the first three paragraphs of its statement; these references were not in the September statement. We expect that Fed communications will not prominently feature the notion of supply chain inflation going forward.
In our estimation, this is aligned with the information about supply chain inflation that the central bank gleaned from third quarter corporate earnings; that information, however, pointed to an easing in those factors going forward.
The Fed’s asset holdings
The Fed is now holding $5.5 trillion of Treasury securities that were purchased during its quantitative easing programs over the decade after the Great Recession and then accelerated during the pandemic.
Given the Fed’s policy decision on Wednesday, it is almost a certainty that the Fed balance sheet will top out at above $9 trillion before it ends its tapering operations next summer.
The purpose of those purchases was to maintain downward pressure on medium- and long-term interest rates to facilitate investment, and to inject cash into the economy to create demand for goods and services.
Those purchases have influenced the bond market, and their impact was noticeable during 2016-18 when 10-year yields began to stabilize and then increase as the Fed maintained its holdings at $2.5 trillion and then allowed those holdings to gradually fall as bonds matured.
But that’s not to say that economic growth and the diminished threat of inflation during that period were not factors in determining the level of interest rates. Those factors were part of the Fed’s decision-making process.
The takeaway
We expect the Fed to maintain those gradualist policies coming out of the pandemic recession. It seems most likely that the Fed will follow its playbook from 2013-19, when it first tapered its purchases of securities and then maintained its holdings, until the health crisis and economy are out of the woods and the recovery benefits all levels of income and employment
