United States
The more things change, the more things stay the same?
We are living in interesting times: inflation is running over 4%, unemployment has been falling sharply, annual real GDP is over 5%, and the sci-fi epic Dune is gracing the big screen. You may be wondering: is it 1984 or 2021?
There is one notable difference. In the 1980s, it was common for the Fed funds rate to bounce between 8% and 12%. Today it more commonly swings from 8bp and 12bp. The process of reversing course on monetary easing also looks a world apart, with ‘tapering’ only a recent addition to the lingo.
‘Tapering’ is here
Today, the Federal Reserve took its key first step in removing the emergency policy implemented at the start of the pandemic.
The Fed announced it will reduce its monthly purchases by $15bn a month in total ($10bn of which will be reduced Treasury purchases and the other $5bn in MBS). This puts it on schedule to finish tapering and cease expanding its balance sheet in June 2022. This will be subject to change, however, ‘as conditions warrant’.
Tapering is not tightening
Even once tapering is over, it is important to remember that the Fed will continue to purchase Treasuries and MBS. It will not ‘print’ new money to do so, but will instead continue to reinvest maturing debt to maintain the size of its balance sheet at a new cumulative high of ~$9trn (Figure 1).
Figure 1: The Fed’s balance sheet will remain at ~$9trn for some time yet1
As such, the Fed will remain a dominant owner of Treasury securities well beyond the forecastable horizon.
The process of reducing its balance sheet (by allowing maturities to ‘roll off’) could be a long way away yet. The last time the Fed finished tapering was in October 2014, and it only started the gradual process of reducing its balance sheet in 2017.
The Fed’s purchases will still be more than enough to support markets for months
While the Fed enacts tapering, the Treasury Department will also taper its supply of bonds.
The Treasury’s borrowing needs will fall as the economy continues to rebound and pandemic-related spending programs run their course. In fact, just today the Treasury announced a $17bn cut in monthly supply, with further cuts set to follow. As such, we expect the budget deficit to fall by over $1.5trn next year.
In total, we expect Treasury issuance to decline by over $1trn. This will actually more than offset the decline in the Fed’s purchases.
The net result will still be more cash chasing fewer assets. In other words, we believe the ‘wall of cash’ supporting financial assets is not going away.
The next policy frontier will be a rate hike – but perhaps later than markets expect
As expected, there was no discussion of when the ‘lift off’ in rates will happen.
The Fed also continued to describe inflationary pressures as “transitory”, making no effort to signal a hawkish shift or pull forward rate hike expectations from its September estimate of 2023 (see Instant Insights: Wall of cash meets wall of worry).
However, markets now anticipate two rate hikes in 2022. The trend is also visible across other countries. For example, the Bank of Canada has taken a hawkish turn and many others are expected to exceed the Fed in hiking activity (Figure 2).
Figure 2: Markets are anticipating rate hikes across the globe in 20222
We view these 2022 expectations as aggressive, although persistent inflation could lead to the Fed guiding toward a higher ‘terminal’ rate, we expect the first US rate hike in the latter half of 2022 at the earliest.
Rate hikes unlikely until tapering is over
We see it as extremely unlikely the Fed will raise rates before fully completing tapering.
As such, we see interest rate policy as locked at 0-0.25% until next July at the earliest, making the Fed far less sensitive to near-term economic data. This delay can only help the Fed’s dovish wing (see Instant Insights: Tug of war) because it buys time to see if inflation is indeed transitory.
While we expect inflation to stay above 5% for the next few months, during Q2 2022 we expect inflation to begin to moderate notably as base effects fade and supply chains improve (see Instant Insights: Stubborn but stabilizing). If this occurs, lift-off could be postponed until later in 2022 or potentially even 2023.
Today’s meeting is another milestone in the post-pandemic normalization, but there is also no apparent evidence of the dovish wing of the Fed rethinking its policy stance on interest rates. Relative to market expectations, we see the risks skewed towards fewer rate hikes in 2022, particularly as President Joe Biden’s incoming Fed nominees will potentially have a more dovish bias.
So, while the Fed is becoming less accommodative, we believe we are still some time away from tighter policy.
