Monetary policy is always a difficult judgment call. Balancing growing global risk aversion, domestic political turmoil and general uncertainty around the underlying condition of the real economy make this week’s Federal Open Market Committee policy decision a bit more challenging than what many anticipated even just a few days ago.
This week’s FOMC meeting is not likely to include a meaningful announcement on tapering and only modest changes in outlook.
To be sure, Wednesday’s press conference by Federal Reserve Chairman Jerome Powell will feature direct questions on the Fed’s evaluation of what looks like a possible default in the Chinese property sector, another showdown in Congress over the nation’s debt ceiling and what the Fed means by making “substantial further progress” in achieving full employment in the economy.
For these reasons, this week’s FOMC meeting will be an important event even though it is not likely to include any meaningful announcement on tapering its monthly asset purchases and only a modest change in the Fed’s Summary of Economic Projections and dot plot interest rate forecast.
Waiting on tapering
Expect the Fed to put off until November any announcement on slowing its $120 billion a month in asset purchases. If the Fed signals any change, expect different language in the third paragraph of its statement, where the committee may update the risk to the outlook as balanced, which may signal tapering before the end of the year.
In 2013, before its previous round of tapering, the Fed used its statement to signal coming policy action, so it may choose to take that approach this week.
But that requires elaboration on what it means when it talks of making substantial further progress on achieving full employment. Under current conditions, clarifying what that progress entails may be a bit more than the Fed wants to do this week.
The October monthly jobs report, which comes out on Oct. 8, represents an important next step toward substantial policy action for the Fed to start winding down its pandemic-era policies.
If the Fed chooses to send more of a nuanced signal to the markets this week, then it will be up to Powell to use his press conference on Wednesday to shape expectations. Powell will be sure to reiterate the core Fed view, which we strongly agree with, that tapering is not the same as tightening.
What investors desire, but will not get until November, is the identification of the timing, magnitude and pace in the slowing of its monetary accommodation. We expect tapering to be announced in November and begin in December.
When tapering starts, we expect it will be at a 2-to-1 ratio, with a $10 billion-a-month reduction in Treasury bonds and $5 billion a month in mortgage-backed securities. If that is accurate, then we would anticipate an end of asset purchases by the end of the third quarter next year.
The dot plot interest rate forecast, a quarterly summary of FOMC members’ outlook for the federal funds rate, will still imply that the first rate hike will most likely occur in 2023, while there will almost certainly be one or two forecasters who imply a rate increase late next year (up from one forecaster previously).
Rising financial risk
It is important to not get lost in the navel-gazing exercise here: Global financial risk appears to be rising, as does uncertainty around the debt ceiling and the direction of domestic fiscal policy.
These conditions are not conducive to an imminent shift in policy. In addition, Powell is more dovish than most members of the FOMC, so whatever the Fed’s statement signals on Wednesday, the press conference is almost sure to convey far more elasticity in the Fed’s reaction function that the dot plot or the Summary of Economic Projections will. What’s more, if Powell is reappointed as chairman, investors would be wise to expect no rate hike until 2023.
The Summary of Economic Projections, released every quarter, will most likely feature modest changes in the Fed’s expectations of growth, employment and inflation.
We expect a downgrade to this year’s growth forecast, an upgrade in the employment forecast for this year and then an acknowledgement that the inflation rate this year will be higher than what was expected in June, when the previous Summary of Economic Projections was published.
The September summary will feature projections into 2024 and include other possible rate hikes, which may affect investor expectations and could be interpreted as hawkish.
We would caution that the Fed will not be in any hurry to begin paring back its monetary accommodation given the rising global economic risks including the spread of the delta variant, new uncertainty in China and the looming battle over raising the nation’s debt limit.
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