Markets

The Fed Is About to Set Its Post-Crisis Policy Course — With a High Level of Uncertainty Ahead

Graeme Jennings | Reuters
  • The Federal Reserve, upon the conclusion of its two-day meeting Wednesday, will almost certainly announce it is reducing the amount of bonds it buys each month.
  • That means the central bank is stepping away from a historic level of support for the economy and into a new regime in which it will still be putting its tools to use but to a lesser degree.
  • Though the move to cut the $120 billion a month in bond purchases has been well telegraphed, there is still risk for the Fed.

When the Federal Reserve adjourns its meeting Wednesday, it will be doing more than scaling down its economic aid. The central bank will be charting a course for its post-pandemic future.

Virtually everyone who cares about such things anticipates the policymaking Federal Open Market Committee, upon the conclusion of its two-day meeting, will announce that it is reducing the amount of bonds it buys each month.

The process, know as "tapering," probably will commence before November ends.

In doing so, the Fed will be stepping away from a historic level of support for the economy and into a new regime in which it will still be using its tools to a lesser degree.

Though the move to cut the $120 billion a month in bond purchases has been well telegraphed, there is still risk for the Fed in how it communicates where it goes from here.

Talk up the tapering too much, and investors will get nervous that interest rate hikes are coming. Soft-pedal the move too much, and the market could think the Fed is ignoring the inflation threat. There's risk to both too much optimism and too much pessimism that the FOMC and Chairman Jerome Powell will have to avoid.

"There's just a very wide range of possible outcomes. They need to be nimble and responsive," said Bill English, a former senior Fed advisor and now a professor at the Yale School of Management. "I worry that the markets will think that they're on a steady track to run purchases down and then begin raising rates when they may just not be. They may have to act more quickly, they may have to raise them more slowly."

As things stand, the market is betting the first rate increase will come in June 2022, followed by at least one — and perhaps two — more before the year is out. In their most recent projections, FOMC members indicated a small likelihood of pulling the first hike into next year.

For Powell, his post-meeting news conference should be an opportunity to stress the Fed is not on a preset course in either direction.

"He needs to note that there are risks on both sides. Of course, there are risks that the inflation we've seen proves more persistent than they hoped," English said. "I'd like to hear him say there are downside risks. Fiscal policy is tightening a lot."

Indeed, at a time when the Fed is starting to pull back on its monetary policy help, Congress is providing less help from its side after pouring more than $5 trillion into the economy during the Covid crisis.

Whereas fiscal spending added nearly 7.9% to the economy to start 2021, that has morphed into a drag that will see it subtract close to 3.8% by the middle of 2022, according to a gauge developed by the Brookings Institution's Hutchins Center on Fiscal and Monetary Policy.

That makes circumstances even more challenging for the Fed.

'A big change in tune'

The committee uses its post-meeting statement to describe how it feels about economic conditions — GDP, employment, housing, trade and the pandemic's influence – and how they could feed into policy.

Through the pandemic, the Fed has developed boiler-plate language stressing economic growth but continued risks from the pandemic that necessitate easy policy. This meeting, though, will likely see substantial changes to that statement to lay out a new course.

"It's a big change in tune," John Hancock Investment Management co-chief investment strategist Matt Miskin said. "You go back six months, and the Fed was completely dovish. They were confident in the transitory component [of inflation], they were confident in the economy doing well, and they still had the time needed for healing, and it's really changed. So, we do see a lot of change in language."

In recent days, Powell and his colleagues have been walking back the "transitory" call on inflation. Instead, they have been saying that price increases have been stronger and longer lasting than they had thought, and stress that the Fed has the appropriate tools — rate hikes — to address the situation.

"The Fed has wanted inflation for much of the last 10 years, and they were unable to generate it with [quantitative easing] and low interest rates," Miskin said. "But now it's here, and it just goes to show you have to be careful what you wish for."

The post-meeting statement, then, likely will reflect the inflation realities as well as the changing shape of the economy as it heads into 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 transitory factors" to adding a qualifier like "largely" or "partly;" and perhaps some guidance either from the Powell news conference or the statement that will emphasize the Fed is tapering without tightening.

After all, the Fed will still be purchasing more bonds than it ever had pre-crisis for the next several months, and its $8.6 trillion balance sheet will continue to grow past $9 trillion in the early part of next year. There are no discussions yet on when the Fed will actually reduce its bond holdings, and that likely won't come until rate hikes are underway.

"We think Powell will likely use the press conference as an opportunity to underscore that the end of tapering does not automatically mean the beginning of hikes. He will likely emphasize that the two policy actions are distinct," Bank of America Global Research said in a note.

Markets are prepared for the Fed taper, but such occasions can be source of market volatility. So Powell will have to choose his words carefully.

"The market's already priced in a relatively swift taper 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," English, the former Fed official, said. "It would be helpful if he just added that the world is an uncertain place and we're not locked into anything, we'll adjust as we need to changes in the outlook."

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