The Fed is on the verge of defining its post-crisis policy – with a high level of uncertainty ahead


Federal Reserve Chairman Jerome Powell testifies during a hearing of the United States House Oversight and Reform Subcommittee on the coronavirus crisis at Capitol Hill in Washington, United States on 22 June 2021.

Graeme Jennings | Reuters

When the Federal Reserve adjourns its meeting on Wednesday, it will do more than cut economic aid. The central bank will chart a course for its post-pandemic future.

Pretty much anyone who cares about these things anticipates that the Federal Policy Development Committee, at the end of its two-day meeting, will announce that it will reduce the amount of bonds it purchases each month.

The process, known as “tapering”, will likely begin before the end of November.

In doing so, the Fed will emerge from a historic level of support for the economy and enter a new regime in which it will still use its tools to a lesser extent.

While the decision to cut the $ 120 billion a month bond purchases was well telegraphed, there is still a risk for the Fed in the way it communicates where it is going from here.

Talk too much about the cut and investors will get nervous about upcoming interest rate hikes. Step on the soft pedal too much and the market might think the Fed is ignoring the inflationary threat. There is a risk of both over-optimism and over-pessimism that the FOMC and President Jerome Powell will need to avoid.

“There is just a very wide range of possible outcomes. They need to be nimble and responsive, ”said Bill English, former senior Fed adviser and now professor at the Yale School of Management. “I’m afraid the markets think they’re on a steady course to cut back on buying and then start raising rates when they might not be. They may need to act faster, they may have to pick them up slower. “

As it stands, the market is betting that the first rate hike will come in June 2022, followed by at least one – and possibly two – more before the end of the year. In their most recent projections, FOMC members have indicated that the first hike is unlikely to be postponed until next year.

For Powell, his press conference after the meeting should be an opportunity to stress that the Fed is not on a predefined two-way path.

“He should note that there are risks on both sides. Of course, there are risks that the inflation we have seen will turn out to be more persistent than they had hoped, ”English said. “I would like to hear him say that there are downside risks. Fiscal policy is tightening a lot.

Indeed, as the Fed begins to withdraw aid from monetary policy, Congress is providing less aid on its own after pouring more than $ 5,000 billion into the economy during the Covid crisis.

While budget spending added almost 7.9% to the economy to start 2021, this has turned into a drag that will see them subtract nearly 3.8% by mid-2022, according to a gauge developed by the Hutchins Center on Fiscal and Monetary at the Brookings Institution. Politics.

This makes the circumstances even more difficult for the Fed.

The committee uses its statement after the meeting to describe what it thinks about economic conditions – GDP, employment, housing, trade and the influence of the pandemic – and how they might fuel policies.

Through the pandemic, the Fed has developed boilerplate language emphasizing economic growth but the continuing risks of the pandemic that require easy policy. This meeting, however, will likely see substantial changes to that statement to chart a new course.

“It’s a big change in tone,” said Matt Miskin, co-director of investment strategy for John Hancock Investment Management. “You go back six months and the Fed was completely dovish. They were confident in the transitional component [of inflation], they were confident that the economy was going well, and they still had time to heal, and that really changed. So we are seeing a lot of changes in the language.

In recent days, Powell and his colleagues have returned to the “transitional” call for inflation. Instead, they said the price increases have been stronger and longer lasting than they thought, and point out that the Fed has the right tools – rate hikes – to deal with the situation. .

“The Fed has wanted inflation for much of the past 10 years, and it hasn’t been able to generate it with [quantitative easing] and low interest rates, ”Miskin said. “But now it’s here, and it just shows you have to be careful what you want.”

The post-meeting statement will therefore likely reflect the realities of inflation as well as the changing shape of the economy as it moves towards a post-crisis future.

Bank of America economists and market strategists expect several changes: a note explaining the tapering process and its flexible nature; a change in the characterization of inflation from “reflecting transient factors” to the addition of a qualifier such as “largely” or “partly; And maybe hints from Powell’s press conference or the statement that will emphasize that the Fed is declining without tightening.

After all, the Fed will always buy more bonds than it ever had before the crisis over the next few months, and its balance sheet of $ 8.6 trillion will continue to exceed $ 9 trillion at the start of the year. next year. There are no discussions yet on when the Fed will actually reduce its holdings of bonds, and that probably won’t happen until the rate hikes are underway.

“We think Powell will likely use the press conference as an opportunity to point out that the end of the cut does not automatically mean the start of the hikes. He will likely point out that the two policy actions are separate,” Bank of America Global Research said. in a note.

Markets are prepared to hit the Fed, but such opportunities can be a source of market volatility. Powell will therefore have to choose his words wisely.

“The market is already anticipating a relatively rapid decrease and rate hikes in the second half of next year. So in that sense, I think it’s not obvious that there will be a problem, ”said English, the former Fed official. “It would be helpful if he just added that the world is an uncertain place and we are not locked into anything, we will adapt as perspectives change.”


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