Taper, Taper, Toil and Trouble

The Federal Open Market Committee (FOMC) - the policy setting arm of the Federal Reserve - is scheduled to meet November 2-3. The Fed is expected to vote unanimously to taper its $120 billion a month in asset purchases - $80 billion in Treasury bonds and $40 billion in mortgage-backed securities.

Minutes from the last FOMC meeting in September suggest that the FOMC will begin cutting asset purchases by $15 billion per month, with a $10 billion cut in Treasury bond purchases and a $5 billion cut to mortgage-backed securities purchases. The committee hopes to end the tapering of its asset purchases by mid-2022. It may have to accelerate that timeline if inflation doesn’t moderate fast enough.

The FOMC will have to address the thorny issue of inflation in its statement on policy. The European Central Bank (ECB) is expected to open the door by removing the word “transitory” from its statement. Look for a similar shift at the Fed.

The committee would like to wait until it has completed tapering asset purchases before a liftoff in rates. Chairman Jay Powell said that the Fed could accelerate the tapering process if necessary to get to liftoff sooner; that is looking more probable.

Our own forecast has core PCE (personal consumption expenditures), which excludes food and energy, peaking above 4% by year-end and slowing to 3.5% by mid-2022. The unemployment rate is expected to dip below 4% in the first half of 2022. Those shifts would prompt more rapid tapering and faster rate hikes than the Federal Reserve laid out in its September forecasts. Market participants are now expecting three rate hikes next year; we could see more. The Fed could also allow its massive balance sheet to begin shrinking.

The shifts, coupled with the compression in profit margins that accompanies higher inflation, could take the steam out of equity prices and trigger spillover effects in other countries. Developing economies are struggling with record debt levels, which could become harder to service if they are forced to match or overcompensate for rate hikes by the U.S. to defend their currencies and tame their own inflation woes.

Why would the Fed raise rates if inflation decelerates in 2022? Because it may not slow fast enough to become insignificant for the public. The reason the Fed has a 2% target on inflation is because few struggle to deal with prices moving up too rapidly or falling too quickly when overall inflation is close to 2%.

What would change the course of the Fed? COVID cases are picking up again in Europe as the efficacy of vaccines wanes. That could take a toll on the global demand surge associated with reopening. It could also amplify supply chain disruptions, especially in emerging markets. The UK has seen a new Delta-plus variant that may be even more contagious than Delta and is causing more break-through cases. Change the course of COVID; change the course of the economy.

The administration has been slow in nominating members to fill roles at the Fed’s Board of Governors in Washington. One seat is still open, while the Vice Chair of Supervision position, which was filled by Randal Quarles, lapsed in October. He still has time left in his term as a governor, but the critical role of who regulates the banks is open. The Chair and Vice Chair positions will expire in January. No word yet on whether Powell will be renominated. This is adding uncertainty to the outlook for policy shifts next year.

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