With a focus on a taper, five questions for the Fed

The Federal Reserve Board building on Constitution Avenue is pictured in Washington, USA on March 19, 2019. REUTERS / Leah Millis / File Photo

NEW YORK, Sept. 20 (Reuters) – Investors are fixated on the Federal Reserve’s monetary policy meeting this week as the US Federal Reserve approaches the final quarter of the year, which is expected to be the first to scale back its unprecedented bond purchases will take a step towards normalizing monetary policy.

Although investor expectations are high that tapering will begin in 2021, there is still a great deal of uncertainty about when the Fed will announce bond purchases and then reduce them. The same applies if it then increases interest rates for the first time since 2019, before the pandemic has lowered interest rates to zero.

Here are five of the main topics investors will be watching after the Fed’s two-day meeting on Wednesday.

BOND TAPERING – LIKE SOON IS NOW

Most Fed officials have spoken out in favor of reducing bond purchases starting this year as long as the labor market continues to improve.

While it is possible that the Fed will reduce its monthly purchases of government bonds and mortgage-backed securities (MBS) by $ 120 billion this week due to such a move.

August job data was well below expectations, while blistering inflation fueled by business reopenings following COVID-19-related closings shows signs of moderation. Continue reading

Investors are focused on new signals as to when a decline might start and whether the move is tied to concrete improvement in data, including employment. The Fed meeting in early November will take place before October employment data is in, which may leave policymakers hesitant to make a decision before December.

The pace of the cut will also determine how long it takes to end quantitative easing, which is expected to be completed before the Fed hikes rates. Fed chairman Jerome Powell, who will speak after the meeting’s statement, may also suggest that if economic conditions worsen, the Fed could accelerate, slow down or stop any tightening.

Fed balance sheet

THE PATH OF RATE HIKES

The Fed has carefully tried to separate the schedule of reducing bond purchases from raising interest rates from zero for the first time since March 2020, but that may not be as easy as some think.

If employment continues to improve and inflation remains above target, the conditions for reducing rates may also hold true.

The Fed scared investors in June after policy makers announced they were forecasting two rate hikes in 2023. Continue reading

The “dot plot” in which Fed officials place their forecasts for the federal funds rate will update this month to see whether those expectations have changed. It will also provide an initial glimpse into Fed officials’ expectations for 2024.

If interest rate forecasts turn out to be more restrictive than expected up to this date, the yields on bonds with an interim date, which are sensitive to possible interest rate hikes in this time frame, could rise.

Fed fund futures are priced for the first rate hike in March 2023.

Fed point plot

Will high inflation prove temporary?

The main argument underlying a possible rate hike is whether the Fed will be able to wait for the economic improvement it wants with the tightening, or whether mounting price pressures will force it to act.

The recent slowdown in prices will support Powell’s argument that high inflation will prove temporary. The inflation-indexed swap curve is sloping downward, reflecting expectations that the annual increases in the consumer price index have peaked.

However, it is not clear when the supply chain disruptions that contributed to a spike in overall prices will subside. Also, new restrictions from the potential spread of coronavirus variants are a wild card for whether inflation will accelerate further or stay elevated.

The economic forecasts released on Wednesday are likely to highlight a wide range of inflation projections by policymakers, which may vary as to whether inflation risks are up or down.

inflation

ECONOMIC PROJECTIONS

Policy-makers’ economic forecasts for growth and jobs, which will be released after the March, June, September and December meetings, along with the dot charts, will indicate whether policy-makers are concerned that growth and jobs may lag inflation, what leaves the Fed in a bind policy normalize.

Some investors fear that the US economy could enter a phase of stagflation in which price pressure will rise even with weak growth.

A Bank of America report released earlier this month showed that investors have invested in assets that do better in an environment where very few asset classes typically do well. Continue reading

Pay slips

PROPORTIONAL MBS AND TREASURY REDUCTIONS

Since the beginning of the pandemic, the US Federal Reserve has been buying $ 80 billion in government bonds and $ 40 billion in mortgage-backed bonds a month.

Speculation that the Fed might cut mortgage-backed securities purchases sooner or faster than government bonds have faded as Fed officials downplayed the prospect that MBS purchases contributed to record home prices across the country.

Powell said in July that he expected the Fed to cut back on Treasury and MBS purchases at the same time. Continue reading

Nonetheless, investors will be on the lookout for signs that this policy is being reconsidered.

MBS

Reporting by Karen Bretell; Editing by Alden Bentley and Dan Grebler

Our standards: The Thomson Reuters Trust Principles.

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