The Federal Reserve has tried to suck all the excitement out of next week’s policy meeting, but it nonetheless marks a major turning point as Fed Chairman Jerome Powell and his colleagues start a journey back to a more neutral policy stance after almost two years of doing everything to prop up financial markets.
“We are entering a new phase in the dance between policy and markets,” said Krishna Guha, a former Fed staffer and now vice-chairman of investment bank Evercore ISI, in a note to clients.
The Fed has been buying $80 billion of Treasurys and $40 billion of mortgage-backed securities each month to keep financial markets stable and support the economy as it recovers from the coronavirus pandemic.
Economists say the Fed has signaled it will announce next week that it intends to slow the purchases at a pace of $15 billion per month — $10 billion in Treasurys and $5 billion in MBS — starting mid-month.
At this pace, tapering would be complete by June. Once the taper is complete, the Fed will have the option to raise its benchmark interest rates.
Markets will have to find their footing again after a Fed policy stance that gave a green light to risk-taking.
“The start of tapering increases the risk of yield spikes and changes the balance of optionality between policymakers and risk-takers in ways that may weigh on equity volatility and risk premia, even as ultra-low longer-term yields continue, for now at least, to provide support for risk,” Guha said.
Don’t expect any surprise in the pace of tapering, cautioned Luke Tilley, a former Fed staffer and now chief economist of Wilmington Trust.
“All of the Fed statements until now have been designed and intended to build the expectations of a $15 million a month – they would not want to surprise markets next week and risk having a taper tantrum,” he said.
The Fed will stress the pace of tapering is flexible and depends on the economic outlook.
The central bank doesn’t want to raise interest rates while it is still buying assets. That would be like slamming on the brakes and the gas at the same time, Tilley said.
The key focus next week will be on what the Fed and Powell say about inflation.
Although Powell is likely to stress the temporary or “transitory” nature of most of the price gains, he has softened his view and has more clearly focused on the risks that inflation may move higher and persist longer than generally expected.
“The transitory inflation defense has started to crumble,” said Andrew Hunter, senior U.S. economist at Capital Economics.
Avery Shenfeld, chief economist of CIBC Capital Markets in Toronto said that since the IMF annual meeting earlier this month “central banks around the world are trying to send a new message to markets — that they’re not unaware of the upturn in inflation and the risks that it becomes more than a temporary problem.”
Some economists think the Fed will re-write its policy statement to stress its focus on inflation, while others see no major changes.
The eight-months of tapering will give the Fed time to wait-and-see how the economy develops. Even if economic growth slows, the Fed will continue to taper, Tilley said. Any material slowdown would only push out the timing of rate hikes.
At the moment, the market is pricing in two rate hikes next year, economists said.
Tilley says he expects only one rate hike next year – in December – and then a steady pace of quarter-point increases at every other meeting.
Shenfeld says he doesn’t think the Fed knows what it will do in six months.
The Fed is just “getting the tapering underway at a quick clip and preparing to raise rates should inflation persist,” he said.
“This is just a gentle initial move,” he said.
However, Shenfeld said he now sees two hikes in 2022 up from his prior view of only one move.
The Treasury yield curve has been flattening in recent days
as bond traders question whether the economy can handle higher interest rates.