Fed starts QE wind-down, but rate hikes still a way off
Fed View: Asset purchases should end by June – At the conclusion of its November policy meeting, the FOMC announced a tapering of its asset purchases, as was widely expected. The first reduction in asset purchases will happen in November, a little sooner than our December expectation, but the pace of reductions over the coming months will also be more gradual – with a monthly reduction of $15bn (we expected a $30bn reduction at each subsequent FOMC meeting).
This trajectory would mean asset purchases ending entirely 8 months from now in June, which is in line with our expectations. Naturally, the Fed left the option open to alter thepace of tapering, but we think there would be a high bar for this, particularly given that asset purchases will change on a monthly basis rather than at each policy meeting (meaning that inter-meeting communications of changes might be required). There was little market reaction to the announcement, reflective of how well the Fed had prepared markets for the policy change.
Rate hikes still some way off, but ‘we have to be humble’
The policy statement contained numerous changes in the Fed’s assessment of the economy. Importantly, the characterisation of the current elevated inflation as ‘transitory’ was kept, with the qualifier added that this was ‘expected’ to be the case. There were also new references to ‘supply and demand imbalances’ linked to the pandemic and the reopening, and that the Fedexpected an easing of supply bottlenecks to support the recovery and a fall in inflation. With the first step towards tightening policy now taken, the focus in the press conference naturally shifted immediately to the prospect of rate hikes. Chair Powell stated clearly that the Fed was not even at the stage of discussing whether it had met ‘the lift-off test’, given that the economy is by many measures still some way from being at maximum employment. However, acknowledging that the end of unemployment benefit top-ups and schools reopening had failed (at least so far) to bring significant numbers back to the labour market, Powell said ‘we have to be humble about what we know about this economy’, reiterating that the Fed would not hesitate to act in response to elevated inflation if it judged necessary. He also did not close the door on a potential early rate hike in the second half of next year (our base case is for the first hike to come in 2023). When asked whether the Fed might reach its maximum employment objective by that time, he acknowledged that this was ‘possible’ if trends in the labour market of the past year continued. The key factor determining the answer to this question will be just how much of the potentially hidden slack currently on the sidelines returns to the labour market over the coming months, something that is highly uncertain.