Fed taper edges closer
FOMC Preview: Further taper signals, but a formal announcement in November – The Fed announces the outcome of its two day September policy meeting this coming Wednesday. We and consensus expect no formal changes to be announced at this meeting, although we are likely to get some changes to the policy statement suggesting an announcement on tapering is imminent. Specifically, the Fed could tweak the part of the July policy statement linking the pace of asset purchases to progress toward its goals to something along the lines of: ‘the economy has made further progress toward these goals, and this is likely to warrant a reduction in the pace of asset purchases in coming meetings.’ As a base case, we expect the Fed to formally announce a tapering of its asset purchases in November, with the first reduction in purchases starting in December. With regards to the pace and length of tapering, the July FOMC minutes indicated a broad range of views on this topic, and some FOMC members have also spoken publicly on the matter. For instance, St Louis Fed president Bullard (who has been among the most hawkish of late) called for a relatively short taper, with asset purchases ending in Q1 22.
The only major precedent for tapering by the Fed was the 2013-14 episode, which ultimately lasted almost a full year, with gradual reductions announced at each meeting. We doubt the Fed would opt for a taper lasting quite this long, as the market is now much better prepared than it was back in 2013, with only modest market movements in response to taper hints. At the same time, the balance of risks around inflation are now tilted much more to the upside than at the time of the last taper. Taken together, we expect around a 6 month taper as a base case, with an initial purchase target reduction in December to $60bn per month for US Treasuries (from the current $80bn), and $30bn per month for MBS (currently $40bn). Thereafter, we expect $20bn and $10bn respective reductions to be announced at each subsequent meeting, with asset purchases ending entirely in May or June. This tapering pace would give the Fed sufficient leeway to change course if need be, while ending purchases relatively soon.
Focus on the 2022 rate hike projection
With the September meeting also comes an update to the Committee’s projections for growth, inflation and the path of fed funds rate. We expect the 2021 median growth forecast to be marked down from the rather bullish 7% projection in June (ABN: 6.2%), and the PCE inflation projection to be raised from June’s 3.4% (ABN: 4.3%). Importantly, we expect the Fed will continue to signal that it thinks current elevated price pressures are transitory, with longer term inflation projections likely to remain very close to 2%. The upside risks to inflation have however made some FOMC members more eager to raise rates. Some regional Fed presidents, such as Bullard and even the typically dovish Atlanta Fed president Bostic have openly called for rate hikes to start in 2022. However, Vice Chair Clarida – who is usually more reflective of the more consensus-based Fed board members – said in August that conditions would be met for a hike in late 2022, with actual lift-off starting in early 2023. On balance, we still expect the median expectation of FOMC members to be for a rate lift-off in 2023. However, just 2-3 of the 11 members projecting no hikes in 2022 back in June would need to change for this median expectation to shift to a rate lift-off in 2022. Even if this were to happen, we would stress that this doesn’t mean the Fed would indeed follow through on this – as inflation continues to moderate, FOMC members will likely push back their lift-off expectations again. Our base case continues to be that rate hikes start in late 2023 – consistent with our view that inflation will ease rapidly next year. We are currently reviewing our base case for the Fed ahead of our publication of 2023 growth and inflation forecasts, and hope to communicate our updated view in the coming weeks.