November 2, 2021 – The Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) meets this week and the good money says they’ll announce a “tapering” of their long-term asset purchase program (popularly known as Quantitative Easing, or QE) upon conclusion at 2:00 P.M. on Wednesday. The Fed has been supporting financial markets since the outbreak of the pandemic and the current QE effort has been steady since mid-2020 in the form of buying $120 billion per month in long-term securities ($80 billion in Treasuries, $40 billion in mortgage-backed securities). We expect them to announce a taper of $15 billion per month, which would reduce the purchases going forward, resulting in the end of QE by June 2022. (We recently posted a full presentation on Fed policy and our outlook, available here.)
Fed Chair Powell and other members of the FOMC have thrown the communication effort into overdrive so as not to surprise markets in the manner of 2013. That year, Chair Bernanke appeared to surprise investors in a similar announcement resulting in a “taper tantrum,” a bond market selloff that nearly doubled the interest rate on 10-year Treasuries over the course of just four months. We think that the communication effort has been successful and, if announced, this taper is unlikely to generate a bond market response similar to eight years ago.
The real question is when the Fed will take its foot off the accelerator (tapering) and begin to press on the brake (hiking interest rates). That depends on myriad factors, but mostly on the path of inflation, which has been running high. We expect inflation to decelerate in 2022 and the first rate hike of 0.25% to come near the end of the year followed by regular hikes of 0.25% every three months, as shown in the figure below. There is upside risk for inflation and if it surprises to the upside, the first hike could come shortly after the end of QE.
Federal Reserve balance sheet ($trillions, left) and federal funds rate (%, right)
Data as of September 30, 2021. Sources: Federal Reserve Board of Governors, Bloomberg, WTIA.
Meeting the criteria
As we describe in the full presentation, the FOMC long ago established the criteria for tapering QE. They started by establishing the criteria for the next step of hiking rates, and then worked backwards to establish criteria for this nearer-term step of ending QE. The criteria for hiking rates are:
- A full recovery of the labor market
- Inflation exceeding their 2% goal on a sustained basis
- Expected future inflation must be above 2% for some time
The “working backwards” bit was the FOMC simply saying they would start cutting back on QE once they deemed the economy had made “substantial further progress” toward these three goals. Well, they have. In the press conference following the most recent FOMC meeting on September 22, Fed Chair Powell reiterated a previous statement that substantial progress toward two inflation goals had been met, and that “many on the Committee” believed the same had been achieved for the labor market, but “they want to see a little more progress.” His own assessment was the criteria “all but met,” a very small hurdle.
Job growth did come in below consensus expectations for the past two months but, in our view, remains strong enough for the Fed to taper. We expect a reacceleration in job growth occurred in October and will get a verdict this Friday with the next jobs report.
In recent weeks financial markets, forecasters, and even Fed officials have been moving rate hike expectations earlier in the calendar. Fed funds futures markets are now pricing in the first hike in mid-2022, and one FOMC member even suggested a faster taper that could be completed in the first quarter of next year so they could start hiking rates earlier if needed.
In our view, that is entirely attributed to inflation data, which continues to run hot. And while the data have surprised to the upside, we still think inflation will moderate going forward, much as we did at the start of the summer, and for the same reasons. Much of the current inflation came on the heels of massive stimulus and vaccine-driven reopening, and we expect those impacts to wane. There are supply chain issues in many industries now, but we expect those problems to be solved. On the well-publicized logjam of container ships off the ports of Los Angeles and Long Beach, we note those ports, combined with the four other major ports across the country, processed about 20% more shipping containers year-to-date than in 2018 and 2019. There are still issues with getting containers out of the ports and to their destinations, but that is improving already.
The key risk going forward, as we said in May and maintain now, are labor market shortages which could lead to higher wages and then to higher inflation. The total labor force is down 3.1 million people compared to pre-COVID. We estimate about half of that reduction is from retirement, with the other causes being continued COVID fears, childcare problems, and a reassessment of work by those who are able. We expect some of those workers to return in the coming months and for productivity gains at firms to mitigate the impact on inflation, helping to push the first rate hike into the end of 2022, as shown above. But if inflation surprises to the upside, the Fed may indeed need to hike next summer.
We maintain a positive outlook for the U.S. and global economies, strong enough to be supportive of our current overweight position to equities. We expect the Fed to announce a tapering of QE of $15 billion per month at this week’s meeting, which could push longer-term interest rates higher in a controlled manner (not a taper tantrum) and be supportive of our underweight to fixed income. Inflation is the key wildcard in the outlook. We expect inflation to slow in the coming months and through 2022, leading to a first interest rate hike late in the year. But the risk is to the upside, and we’ll be watching for higher inflation that could bring that first hike as early as July 2022.
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