The building of the Marriner S. Eccles Federal Reserve in Washington.
Stefani Reynolds / Bloomberg via Getty Images
The Federal Reserve will likely begin creeping into the unknown before the end of the year.
Central bank officials said Wednesday that they are ready to begin “rejuvenation” – the process of slowly withdrawing the incentives they provided during the pandemic.
While the Fed has pulled back on monetary policy before, it has never had to withdraw from such a dramatically accommodating position. For most of the past year and a half, it has bought at least $ 120 billion in bonds every month, providing unprecedented support to the financial markets and economy that it will now go back to.
The bond purchases added more than $ 4 trillion to the Fed’s balance sheet, which now stands at $ 8.5 trillion, of which about $ 7 trillion was bought up through the Fed’s quantitative easing, according to the central bank Assets are. The purchases helped keep rates low, helped markets that were badly disrupted at the start of the pandemic, and coincided with a strong run in equity markets.
Given the role the program has played, Fed Chairman Jerome Powell reassured the public on Wednesday that “policy will remain accommodating until we meet the central bank’s goals for employment and inflation”.
Markets have received the news well so far, but the real test is yet to come. The tapering is a discount to future rate hikes, even though they appear to be at least a year away.
“It was certainly well communicated so I don’t think this should shock anyone or disrupt the market,” said Kathy Jones, director of fixed income for Charles Schwab. “The question is really more about asset prices than it is [interest] Prices. We have consistently very high valuations for asset prices. What is the effect of this shift from very easy money to asset prices? “
The answer so far has been … nothing. The market rallied on Wednesday afternoon despite advance notice that the Fed would slow down and stormed up again on Thursday.
The way forward will likely depend on how the Fed tier handles its money printing exit.
How it works
This is what tapering could look like:
Powell said the official decision on the cut could be made at the November meeting and the process will begin shortly thereafter. He added that he sees the tapering to be completed “sometime in the middle of next year.” This timeline then provides a glimpse of how the actual cuts will go down.
If the throttling actually begins in December, a $ 15 billion monthly reduction in purchases would bring the process to zero in eight months or July.
Jones said she expected the Fed to cut Treasuries by $ 10 billion a month and mortgage-backed securities by $ 5 billion. There have been some calls from within the Fed to be more aggressive on mortgages in the face of inflated house prices, but that seems unlikely.
Federal Reserve Chairman Jerome Powell says during a hearing for the U.S. House Oversight and Reform Selection Subcommittee on the coronavirus crisis Jan.
Graeme Jennings | Swimming pool | Reuters
Powell’s general tone during this post-meeting press conference surprised Jones. The Chairman said repeatedly that he was satisfied with the progress made towards full employment and price stability. With inflation well above the Fed’s comfort zone, Powell said that “this part of the test has been achieved from my point of view and from the point of view of many others.”
“The tone was perhaps a little more restrictive than the market expected when it came to tapering,” said Jones von Schwab. “That comment that the Fed will be ready by the middle of next year was, ‘Okay, we’d better get on with this if we are going to do that.'”
Jones said Powell’s comments and the Fed’s intentions reflect a high level of confidence that the economy will continue to recover from the pandemic-induced recession, which was both the shortest and steepest in US history.
“The Fed is telling us that overall they expect growth and inflation to be pretty strong over the next year and they are ready to pull the simple policy back,” she added.
A look at a rate hike
What happens after rejuvenation is really important.
The summary of the rate forecasts of the individual members – the vaunted “dot plot” – indicated a somewhat more aggressive stance. The 18 members of the Federal Reserve’s monetary policy open market committee disagree on whether to approve the first quarter-point hike next year.
Officials see up to three more hikes in 2023 and 2024, bringing the Fed’s benchmark interest rate from the current 0 to 0.25% to a range between 1.75% and 2%. Powell insisted that the Fed would act cautiously before raising rates and likely wait for the tightening to complete, but the market would be on the lookout for more restrictive signs.
“The next Fed meeting could be really interesting. It should give us a lot more volatility than we are seeing now,” said John Farawell, head trader at Bond underwriter Roosevelt & Cross. “They sounded more Hawkish. It will be data-driven and it will be about how Covid is doing.”
It will be a new world for investors with the Fed still providing support, but not as much as it was before. While the mechanics sounds simple, it could get complicated if inflation continues to beat Fed expectations.
FOMC members raised their core inflation estimate for 2021 to 3.7%, up from the 3% projection in June. But there are many reasons to believe that there are significant benefits to this forecast.
For example, over the past few days, business leaders like General Mills and Federal Express have warned that prices are likely to rise. Natural gas has increased by more than 80% this year and will mean significantly higher energy costs in the winter months.
UBS predicts that the economic climate and weakening news will put upside pressure on yields and push benchmark 10-year government bonds to 1.8% by the end of 2021, impacting corporate or individual debt costs, “UBS said in one Message for customers.
Yields are moving in the opposite direction to prices, meaning investors will sell bonds in anticipation of higher interest rates and less support from the Fed.
UBS analysts say investors should keep in mind that the Fed is moving forward because it is gaining more confidence in the economy and will continue to provide support.
“While higher bond yields reduce the relative attractiveness of stocks, a gradual rise in bond yields should be more than offset by the positive impact of rising earnings in normalizing the economy,” the company said. “Tapering should therefore be viewed as a gradual withdrawal of an emergency response as conditions normalize.”
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