Is Fed ready to dial back support for the economy?
While US President Joe Biden has not decided whether to give a second four-year term to the Fed Chair, Mr. Powell is about to announce the first steps towards normalizing monetary policy.
The Fed’s zero interest rate policy and massive asset purchase program are key reasons for the robust economic recovery from the pandemic era. It also elevated prices for most asset classes from bonds to real estate and equities, which continued to achieve new record highs throughout 2021.
On the economic front, employment improved significantly from the worst crisis since the Great Depression; however, it remains elevated compared to the pre-pandemic levels. The economy is growing at an above-trend level and is likely to sustain this growth well into 2023. Inflation remains the big elephant in the room after annual inflation rose at its fastest pace in more than 30 years.
Earlier this year, most monetary policy officials, including Jerome Powell, believed inflation would dissipate. Still, the risk that higher prices will linger for longer has grown significantly for the last several months. As a result, policymakers are now feeling the urgency to get tapering done so that they could act faster in tightening policy if inflation proves to be more persistent.
The Fed is widely expected to announce reducing their $120 billion purchases ($80 billion of Treasuries and $40 billion of mortgage-backed securities) by $15 billion by mid-November or early December. The program is anticipated to conclude by mid-next year, and we’re likely to hear more from Powell about the process.
Scaling back those purchases doesn’t mean tightening policy; it just means the Fed will provide less stimulus to the economy compared to when the program was launched in March 2020. In theory, this should remain supportive to equity prices as long as there aren’t any external shocks.
Given that tapering is already priced in, the focus will shift to timing and the scale of interest rate hikes. That’s what really matters to investors. Monetary policymakers are growing less patient, with half of them already penciling in at least one rate hike by 2022, while three members are projecting two interest rate hikes. If Powell manages to convince markets that the end of the purchase program does not signal the start of a new rate hike cycle, and the rise in prices is not scaring Fed officials yet, the bull market may still have legs.
On the other hand, sounding more hawkish by signaling faster taper or more aggressive rate hike cycle will lead to a selloff in risk assets and strong appreciation in the dollar. While this is not the base case scenario, as an investor or trader you need to be prepared for any outcome.