Hawks Rule the Roost

The Federal Open Market Committee (FOMC) voted unanimously to keep rates unchanged and signaled that members are getting ready to taper the Fed’s purchases of Treasuries and mortgage backed securities. “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” Chairman Jay Powell underscored that the FOMC is split on when to act, but could begin to taper as soon as the next meeting in November. Some participants fear the Fed is already behind the curve on tapering; they are concerned about more persistent inflation and seeding asset price bubbles.

Powell admitted that the threshold on employment has almost been met when it comes to tapering asset purchases. He would accept a decent, if not spectacular, gain in employment in September in order to begin tapering in November. The chairman tried to keep tapering separate from liftoff for short-term interest rates, arguing that the threshold for rate hikes is much “higher” than for tapering.

What would prevent Federal Reserve officials from tapering in November? A major shortfall in employment for September, something less than the 235,000 job gains we saw last month. A failure to lift the debt ceiling in Congress. Or, a meltdown in China stemming from its largest real estate fund, Evergrande. Powell stressed that the debt ceiling must be raised, given the risks to the overall economy of a major default in U.S. debt. Chair Powell worked aggressively with the Bipartisan Policy Center in 2011 to avert a default back then, which garnered respect for him on Capitol Hill and led to his nomination as a governor on the Federal Reserve Board in 2012.

The FOMC released its quarterly economic forecast. As expected, prospects for growth were revised lower, while forecasts for inflation were revised higher. The committee is now evenly split between those who expect the first rate hike in 2022 or 2023. At least three of the four incoming regional presidents who will be voting on policy next year had penciled in rate hikes for 2022 back during the June FOMC meeting. I am betting that all four rotating onto the committee are planning for rate hikes next year. This means we could see more than one dissent if the Fed were to delay raising rates despite persistent inflation.

Chair Powell stuck to his guns and argued that the inflation we are enduring is transitory. He reiterated his view that the Fed has the tools to deal with a more persistent inflation, if it had to. That is easier said than done. More rapid rate hikes as the Fed chases inflation not only up the ante of an overshoot or boom/bust in the U.S. but could destabilize emerging markets. Debt issuance by emerging markets, which have fewer resources to service that debt if rates rise, has soared since the onset of the crisis.

Separately, the Fed Chair was asked about the conflict of interest in bond trades by two regional Fed presidents; Powell said he thought they were wrong.

Bottom Line
The Chairman is a dove among hawks. He would like to divorce tapering from rate liftoff and stressed that the threshold for rate hikes is much higher than for tapering. The forecast and the dot plot (which shows voting and nonvoting participants’ views on rates) suggest more within the Fed are concerned inflation will become a larger problem in 2022. Next year could be a roller coaster for financial markets.

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