The Federal Reserve is planning to slow the pace of its $120 billion in monthly asset purchases even as it keeps its policy rate at zero, it suggested in its policy statement released on Wednesday. The statement came as the central bank is split on whether to begin raising rates late next year or in early 2023.
The central bank is split on whether to begin raising interest rates late next year or in early 2023.
The Fed’s interest rate forecast, known as the dot plot, showed that nine members of the Federal Open Market Committee expect the first rate hike to be next year, up from seven in June.
This debate over raising the policy rate will now move into focus even as Federal Reserve Chairman Jerome Powell made the case that the onset of tapering does not signal the timing of the first rate hike.
The Fed’s statement added notable language into its policy paragraph that had not appeared in recent statements: “If progress continues broadly as expected, the committee judges that a moderation in the pace of asset purchases may soon be warranted.”
The new language was a signal that the central bank is preparing to end its pandemic-era asset purchases over the next year and was a bullish sign of confidence in the economy.
This confidence comes despite the risks around the pandemic, the direction of domestic fiscal policy, the financial challenges in China and the looming showdown over raising the nation’s debt ceiling.
We will continue to make the case that Powell is more dovish than most of his committee members. Should he be reappointed as chairman, then we would anticipate that it will be 2023 before the first rate hike.
Timing of the tapering
On the slowing of monetary accommodation, we expect a November announcement followed by a December start date that features a $10 billion monthly reduction in purchases of Treasury bonds by the central bank and a $5 billion reduction in purchases of mortgage-backed securities.
If the Fed employs that pace of reduction in asset purchases, then they should end in the third quarter of next year or around next September’s meeting of the FOMC. This will be the focus of the upcoming FOMC policy rate decision on Nov. 2.
Expect upcoming Federal Reserve speeches to underscore that reduction as the Fed tries to shape near-term market expectations during a time of economic uncertainty.
While the central bank chose to signal a reduction in its asset purchase program, it did not provide a more fully defined definition of what it means by achieving substantial further progress toward full employment, which is one of its mandates.
The ultimate direction of policy, as well as the timing, magnitude and pace of that tapering program, is a function of the labor market. Should the monthly employment reports be disappointing, that could push back the onset of that now-expected policy action until early next year.
Waiting on the jobs report
The upcoming September jobs report, which will be released on Oct. 8, now looms large as the next big event across the policy space and for financial markets, save the resolution of the pending debt ceiling showdown in Washington that will also play a role in the start of tapering operations.
Powell stated that when tapering begins, it will not be a signal for the start of rate hikes. So one should expect further shaping of investor expectations as the Fed attempts to avoid another “taper tantrum” of the type that occurred late 2013.
The Fed’s Summary of Economic Projections, which was also released on Wednesday, and its policy statement both communicated to investors and policymakers that the Fed believes that the recent increase in inflation is transitory and the result of a historic supply shock that will dissipate in the coming months and years.
The Fed expects that the core personal consumption expenditures inflation rate—one of its key policy variables—will end the year at 3.7%, next year at 2.3%, 2023 at 2.2% and 2024 at 2.1%, with the first three above the June forecast and the 2024 projection, a new addition to the SEP.
Powell went out of his way to communicate his dovish forecast of inflation and underscore the central bank’s view that the recent increase in price volatility is transitory.
In particular, he reiterated that bottlenecks in supply chains, which are behind the upwardly revised forecast on inflation, have lasted longer than anticipated. But Powell still expects those bottlenecks to ease over time.
As expected, the growth forecast was revised down to 5.9% for this year, to 3.8% for next year, to 2.5% in 2023 and to 2% in 2024. The unemployment rate forecast was revised up to 4.8% this year, kept at 3.8% next year and at 3.5% in 2023 and 2024.
This would imply that the Fed expects full employment to stand somewhere between 3.5% and 4%. The long-run federal funds rate remains at 2.5%, which implies a real long-term neutral rate of somewhere between zero and 0.5%, both of which would strongly indicate that interest rates will remain quite low for the foreseeable future.
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