At the close of yesterday’s Federal Open Market Committee meeting, Chairman Jerome Powell addressed the 8-trillion-pound gorilla in the room: when and how quickly the U.S. central bank plans to taper its large portfolio of debt. Powell said the reduction in the Fed’s asset purchases could begin as soon as November’s FOMC meeting, confirming the expectations of imminent tapering.
But the Fed chief also tempered any possibility of a tantrum by emphasizing the central bank’s cautious attitude towards interest rates, saying that the “timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest-rate liftoff.” Powell signaled that a hike in 2022 is a possibility, but not guaranteed. Although rates were already low before the pandemic, a rate hike in 2022 would telegraph an important milestone in the U.S. economy’s economic recovery from the public health crisis.
“Overall, the September meeting turned out to be somewhat on the hawkish side,” said Christian Scherrmann, U.S. Economist. “By adjusting its economic outlook to the economic reality, the Fed opened the door for a taper announcement in November, very much in line with our expectations. The prerequisite for this, however, will be that hiring activity in September shows the promised upside from the run-off of the extended unemployment benefits.”
The investor response was muted, if not positive, towards the policy pronouncements. The S&P 500, Nasdaq, and Dow indexes all rose modestly in after-hours trading. “I believe that there are no significant implications for the stock market from today’s Fed meeting [as] tapering is not likely to have a meaningful impact on the economy,” said Eric Winograd, Senior Economist at AllianceBernstein. “At this point in the cycle, the value of QE is the forward guidance that it provides in terms of the liftoff date for rate hikes rather than anything to do with the asset purchases themselves.”
The confident reaction of stock market investors could also be a dual-response: to the Fed’s reassurance, sure, but also to the fact that spillover from the collapsing Chinese company Evergrande appears better contained than originally thought. Still, Fed officials will be following closely the recent tremors in global credit markets, and whether any U.S. financial institutions are exposed to further sell-offs.
“Credit market disruptions such as Evergrande now become another chainsaw that the Federal Reserve must juggle in regards to credit spreads expanding in sympathy,” said Matt Lloyd, Chief Investment Strategist at Advisors Asset Management.
Inflation will be key to any Fed decisions. Powell said they’re predicting an annual inflation rate of 4.2% for 2021, up from their 3.4% forecast in June. “Interest rate decisions hinge on whether or not the current hot inflation is still “transitory,” says Dan North, Chief Economist at credit insurance company Euler Hermes. “There is a good case to be made that it may be a long time until the supply chain problems are cleared up, and input prices will continue to rise very sharply and get passed on to consumers.” If supply chain issues persist, that’s bad news for a range of industries, from semiconductors and homegoods to automobiles. But the Fed is more optimistic, projecting that inflation will cool to about 2.2% next year.
Some market strategists believe rate hikes are further off than Powell indicated possible. John Lynch, CIO of Comerica Wealth Management with $50B in AUM, believes any rate increase remains a “long way” off, citing the steep costs of servicing existing debt, the dynamic between the yield on U.S. 10-year treasuries and negative yielding debt in the market, and Powell’s emphasis on making “substantial further progress” in labor and output.
Indeed, the Delta variant disruption has stalled the economy’s full recovery. How quickly the U.S. overcomes further Covid hurdles will have an important bearing on upcoming Fed decisions.
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