September FED meeting: waiting for November

There were talks on Inflation, as it is elevated at the moment, and it is likely that it remains like this in the coming months before moderating. There were also talks of spending rebounds, and supply bottlenecks.

Investor Relations Specialist

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The FED met this week, and the outcomes from this meeting were similar to the the previous ones. There were talks on Inflation, as it is elevated at the moment, and it is likely that it remains like this in the coming months before moderating. There were also talks of spending rebounds, and supply bottlenecks. We have received the first commentaries from the professionals within the asset management industry.

Christian Scherrmann, U.S. Economist DWS

In today’s September FOMC meeting the Fed stopped short of declaring “sufficient further progress” to change monetary policy but tilted further towards tapering – just as we expected.

Indeed, we got the change of language we were looking for in the statement, following closely what Fed Chair Powell already announced in Jackson Hole: ”If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” Fed Chair Powell specified in the press conference that the start of tapering could come as soon as in the next meeting and the end-point for purchases likely could be by mid-2022. And, along with this, the updated Summary of Economic Projections now indicates somewhat lower growth and higher inflation in 2021. “Transitory” price increases might therefore now, in the Fed’s view, prove more persistent than previously thought, especially as the 2022 numbers were increased slightly as well.

Besides somewhat higher expectations for growth too in 2022, there were only minor changes in the other forecasts. The just released predictions for 2024 indicate that FOMC participants expect a smooth transition of the economy towards its potential growth rate. The dot plot, meanwhile, now indicates one hike in 2022 at the margin as some more participants indicate that they are in favor of an earlier lift-off from zero interest rates. But a significant lift-off of interest rates is only indicated in 2023 and they follow a linear path through 2024 – for both years three more rate hikes each are expected.

Overall, the September meeting turned out to be somewhat on the hawkish side. 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. Some clarity on the still looming debt ceiling and possible government shutdown would also be helpful. If the shutdown continues to threaten or that threat even escalates, the Fed playbook will most likely be rewritten, with a more dovish twist.

Anna Stupnytska, Global Economist, Fidelity International

In a challenging week for financial markets, the Fed signalled in its September meeting that tapering of asset purchases ‘may soon be warranted’, in line with expectations. All eyes now look to November as the most likely start date for the unwind of extreme policy accommodation. At the press conference, Powell signalled he expected tapering to conclude by the middle of next year, which is somewhat more hawkish than market expectations.

The dot plot signalled a moderately more hawkish tilt relative to its June version, suggesting two more FOMC members now favour an earlier lift-off in 2022 and the 2023 median dot has shifted up to 1%. The Summary of Economic Projections showed a slower growth for 2021 but an upgrade for 2023, while the inflation path has been upgraded over the forecast horizon, with PCE inflation now expected to be above target through 2024.

With inflation pressures likely to prove more persistent and growth risks skewed to the downside over the next few months, the path for policy normalisation looks narrow and challenging, with much room for policy missteps.

Silvia Dall’Angelo, Senior Economist Federated Hermes

The Federal Reserve has confirmed that the process of pulling back policy support is due to start soon. The statement hinted at tapering starting by the end of this year, with a formal announcement likely to take place in November, provided the labour market delivers positive news and there is no other accident. The dot plot also showed that the median FOMC participant now expects the hiking cycle to start in 2022 – few quarters earlier with respect to June’s projections – and to include 163bps of cumulative rate increases to the end of 2024.

That said, while ‘substantial progress’ in the labour market and inflation justifies a reduction in the pace of asset purchases starting later this year, the goal of maximum employment is still some way off and calls for monetary conditions to remain accommodative for some time to come. For these reasons, Powell will make sure that the distinction between tapering, the end of asset purchases and interest rate lift-off is clear. Indeed, Fed purchases will likely continue at a reduced pace for the best part of next year and the policy rate will likely remain low for a long time, with a slow hiking cycle following a late lift-off. 

The Fed is on track for tapering towards the end of this year, but that might take place at an awkward time, as growth, inflation and fiscal stimulus are probably past their peaks, while risks surrounding the evolution of the pandemic have not disappeared. In addition, new risks concerning domestic political dynamics and international developments – most notably, turmoil in the Chinese property sector – have emerged. All these considerations will eventually determine the path for the removal of monetary policy support – a process that is likely to be drawn out and cautious. 

Paolo Zanghieri, Senior Economist, Generali Investments Partners

The Fed signaled a strong conviction to speed up normalization, explicitly indicating that the November meeting could stage the announcement of the beginning of tapering. Moreover the rate liftoff could already take place in 2022. The hawkish turn was motivated by a stronger belief that, despite some signs of deceleration (see table at the end), the underlying dynamics of the economy is strengthening and by the preoccupation that a longer lasting inflation overshooting ends up in raising expectations.

The press release contained small but significative changes. On the economy, the FOMC signaled that Risks related to COVID are receding in line with the slowdown of infection. But it also remined that inflation is “elevated”. On the policy front, a continuation of the current pace of labour market improvement would soon warrant a reduction in asset purchases.

The projections reflected the speed bump the economy is facing as supply bottlenecks hamper activity in several sectors. While 2021 growth was downgraded markedly, the longer-term growth outlook was revised slightly up. Job creation is projected to be a bit slower this year in comparison with the June projection, but the target of unemployment rate at 3.8% by the end of 2022 remains achievable. This is the level some Committee members have associated to full employment. Higher than expected realized inflation for this year translated into a sharp upward revision of the short-term outlook. The transitory character of the overshooting remains, but Powell admitted that higher inflation due to bottlenecks could drag into 2022. 

In the press conference, Powell stated that the progress needed to begin tapering was already attained on inflation and is very close on employment. He reckoned that over 50% of the gap between actual and equilibrium unemployment has already being bridged. Moreover, the FOMC dismissed the weak August employment as the result of the residual drag on labour market participation caused by childcare and fears of contagion. Both factors should disappear quickly during the autumn, allowing employment to accelerate. Powell called “inexorable” the return to work of the people laid off due to the pandemic.

As most FOMC members believe that the substantial further progress on employment is around the corner or has already been achieved, QE has lost most of its usefulness and some FOMC members have voiced concerns about financial stability. Therefore, Powell clearly stated that tapering should be announced already at the next meeting (Nov. 3). The bar for a delay is rather high: the FOMC looks at the cumulative labour market improvement and only a strong disappointment from the September employment report would lead the committee to pause. There is also a strong agreement on a quick pace of tapering.

The FOMC thinks it should end by mid-year: this implies a reduction of purchases by roughly US$ 15bn per month. The discussion on how to shrink the balance sheet will begin only when tapering is underway.  

The reshuffling of the dots for 2021 lead the median to move up signalling a rate hike already in 2022. Powell took care of stressing that the FOMC is evenly split on the issue: nine members predict a move by the end of next year and the remaining nine holding off until 2023. In June, seven officials saw a rate rise next year. They also project a faster pace of rate normalization, with three hikes in 2023 (against two in June) and in 2024. At the end of that year the policy rate will reach 1.75. We expect that level to be reached with a slightly different, more cautious, path: we now pencil in a rate hike towards the end of 2022, only two in 2023 and four in 2024. 

The steepening of the fed funds path is meant to provide a strong signal of the commitment to rein in any possible upward slippage in expected inflation. Powell said several times during the Q&A session that long term expectations have risen back to the 2013 levels and have so far showed no signs of deanchoring. 

Finally, Powell declined to comment on the debt ceiling issue and played down the risks that the Evergrande troubles can create to the US economy. Direct exposure of the financial sector is limited. He also strongly denied any parallel with US corporate debt. Concerns about leverage were high hat the beginning of the pandemic, but the strong policy response has kept defaults low.

Sebastien Galy, Senior Macro Strategist at Nordea Asset Management

Federal Reserve moves towards November Taper. The Federal Reserve is very likely heading for a tapering of its bond purchases in November, but the longer-term outlook depends on how transitory the current bout of inflation is. If we are correct, i.e. it will fade more quickly than expected, then we should see the expectation of rate hikes delayed, supporting a further upward move in North American equities. 

Federal Reserve decision

The Federal Reserve signaled this week that it would most likely be tapering its bond purchases in November provided it had a decent labor market print and if conditions were almost met (defined as substantial progress on its inflation and growth mandates). Faced with elevated break-even inflation for the next few years,  the Fed increased its own inflation forecast, leaving the odds of a rate hike next year in the dot plots. What was interesting is the relatively subdued pace of forecasted interest rate increases from 2023 on. It suggests that the Fed believes long-term deflationary forces will come to the fore. This communication exercise is designed to keep the front end of the US Treasury curve well-contained to give time for the economy to grow. What we suspect will happen is that the Fed will be too slow to tackle the elevated degree of leverage in the system, leading to a correction in the resulting asset bubble in circa H2 2022. 

Dynamics of growth and inflation

The Federal Reserve is tapering at a time of a deceleration of the US economy, leading to calls of stagflation – namely elevated inflation and stagnant growth. Indeed, even the Fed is becoming less convinced that inflationary pressures will ebb quickly while inflation expectations in the market are elevated for the next few years. The problem the Fed is faced with is that there are a plethora of shocks of various intensities that are destabilizing households’ expectations of a stable inflation. The Fed can contain some of these pressures by tapering and simply gaining time by taking back control of the narrative, but there is also a long term supply chain issue where the Fed has little control. However,  we are already getting testimonies that hiring for warehouses is becoming easier now that Federal supplementary unemployment payments have disappeared. 

Impact for the markets

Even though this Fed tapering is not completely what the market expected, it settles the question as to how the market would react  in the short-term namely somewhat higher long-term yields. Its long term effect is harder to predict though. Liquidity being retrieved all along the US Treasury curve by the Fed should easily meet liquidity sloshing around in cash, both in the United States and abroad in a world starved for safe assets that generate yield. One unexpected consequence of tapering is likely that over time the US bond market is going to compete against the EM bond market – which had been one of the key fears of tapering as yields in the US become more attractive. 

What does it mean?

The Fed didn’t fully deliver what the market expected leading to somewhat higher US Treasury yields, but the fear of tapering is fading and with it fears of a broader economic slowdown led by China, hobbled by a budding real estate crisis. That leaves equities in advanced economies to likely outperform in the coming weeks against a wall of worries as is typical of an advanced carry trade.

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September FED meeting: waiting for November