Overnight, the Federal Open Market Committee made no changes, leaving the fed funds rate at 0.00-0.25% and quantitative easing at USD120 billion a month. By failing to start tapering bond buying - despite inflation running well above the Federal Reserve’s 2% target as the chart shows - the FOMC was dovish. Risk assets rallied with the S&P 500 up 0.95%. But the Fed still made key changes to its forward guidance and forecasts.
First, the FOMC made it clear it will announce at its next meeting on November 2-3 that it will start tapering its quantitative easing ‘if progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.’ Thus, only a weak payrolls report on October 8 may stop tapering being announced in November now.
Second, the Fed signaled faster tapering was likely. Chairman Powell said: ‘while no decisions were made, participants generally view that, so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.’
Third, the FOMC updated its forecasts, showing officials were evenly split 9-9 on whether to start raising the fed funds rate in 2022 after quantitative easing ends. For 2023, the median FOMC forecast was revised up to show three 25bps rate hikes compared to two rises before. And the new 2024 forecasts project three further 25bps hikes, bringing the fed funds rate to 1.75%.
Source: Bank of Singapore, Bloomberg.
Last, delta virus cases caused the FOMC to downgrade its 2021 GDP forecast from 7.0% to 5.9%. Its core inflation forecasts, however, were raised to 3.7%, 2.3%, 2.2% and 2.1% for 2021, 2022, 2023 and 2024. Thus, the FOMC expects inflation to be moderately above its 2% goal even in 2024.
We expect the Fed will announce tapering at its November meeting but will now reduce its bond buying at a faster pace of USD15 billion every month rather than at every FOMC meeting. Thus, the Fed’s quantitative easing is set to end in June next year rather than in September 2022.
We also expect the Fed will now start increasing its fed funds interest rate in 2023 rather than in 2024. Powell said: ‘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 lift-off.’ But the faster pace of tapering and the end of quantitative easing in mid-2022 makes it likely the Fed will announce two 25bps hikes during the second half of 2023 and three-to-four further increases in 2024.
The FOMC would thus be hiking rates roughly once a quarter similar to its last tightening cycle in 2017-2018. This would support the USD in future. But with gradual rate rises still two years away, and the Fed’s leadership staying dovish despite inflation over 2%, the FOMC’s stance will keep benefiting risk assets. Treasury yields are set to steepen once tapering starts but we still see 10Y yields only rising to 1.90% over the next 12 months.Disclaimer applicable to recommendation
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