The Federal Reserve is set to start tapering its quantitative easing (QE) when its Federal Open Market Committee (FOMC) meets on November 2-3.
The first chart shows the Fed and the European Central bank (ECB) have been printing money and buying bonds massively during the pandemic, far more than previous rounds of QE after the 2008 financial crisis.
But with inflation above the Fed’s 2% target as the US economy reopens and unemployment down to 4.8% from 14.8% at the height of the pandemic, the FOMC now is widely expected to claim ‘substantial further progress’ has been made to enable the Fed to start tapering its USD120 billion a month pace of asset purchases.
Thus, the Fed’s likely decision to begin slowing its bond buying in November and ending QE altogether by the middle of 2022 shouldn’t cause a ‘taper tantrum’ that hurts risk assets.
The FOMC is also set to signal that interest rate hikes are only likely to occur a considerable time after the Fed has finished printing money - again to the benefit of risk assets. The Fed’s senior leaders including Chairman Jerome Powell and New York Fed President John C. Williams continue to argue that increases in inflation as economic activity reopens will still only be transitory.
But the Fed is likely to warn that supply chain disruptions and higher energy prices will keep inflation above its 2% target well into 2022. The second chart shows the Fed’s target measure of inflation - changes in core personal consumption expenditure (PCE) prices - is running at 3.6% and will likely peak above 4% in 2021 before declining back towards the Fed’s 2% goal next year.
Thus, the FOMC will keep watching inflation risks and inflation expectations closely. Financial markets too will continue to be wary of the threat of inflation increases becoming entrenched - rather than proving to be only temporary. But the Fed is still likely to wait until the spring of next year before deciding whether inflation increases are set to be sustained and thus require earlier interest rate rises in 2022 rather than later in 2023. Until that time and decision, the Fed’s dovish stance will keep supporting risk assets.
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