How plausible is the Fed’s plan for tapering and rate rises? Our view is that the near-term risk (30%) is for a later and/or slower pace of tightening. But the longer-term risk is the other way – a faster pace of rate rises due to higher inflation than expected.
The Fed yesterday sounded slightly more hawkish than previously but markets took the news calmly. This was perhaps because the Fed has been gradually converging towards the market’s upbeat view of the economy all year but only in a reassuringly slow and cautious way, with plenty of careful communication.
The Fed’s moves will be, as always, contingent on the US data. That said, Chairman Powell clearly expects tapering to start soon, likely at the November FOMC meeting. The Chairman was also very clear that tapering is likely to conclude by the middle of next year, which implies reductions of about $15bn per month from the current $120bn purchases of bonds every month.
The main risk to the tapering timetable is that it is delayed or slowed because of weaker than expected US data, most likely because Covid variants lead to new social distancing. There is also a small chance that China’s Evergrande crisis blows up badly, making the Fed hold back for a while. However, our view (link to previous blog) is that the Chinese government will avoid a financial crisis, even though it can’t avoid an economic slowdown. More on Evergrande next week.
Rate rise timetable
The majority of FOMC members now expect the first rate rise in H2 2022 with 3 more rate increases in 2023 (to 1%) and 3 more again in 2024 to 1.8%. By the second half of next year the risks to the Fed’s tightening path are likely two way. It is possible again that growth by then is too weak to justify continuing with the tightening programme. Again, Covid could be the culprit or perhaps a major economic slowdown in China by then (following from Evergrande), could dent the recovery.
But there is probably a greater chance that growth is solid or even quite strong and that inflation is becoming a major concern. At present neither the Fed nor the markets expect inflation to be a problem beyond the next year or so. The median expectation of FOMC members puts core PCE inflation at 2.3% in Q4 2022, which is right where they want it to be (just above 2%). And market breakeven inflation expectations, although higher than for many years, are only at about 2.5% on a five year view (see chart).
This view of inflation could be too sanguine. True – recent high inflation numbers largely reflect transitory factors such as higher gasoline prices and the extraordinary rise in used car prices due to a shortage of semiconductors holding up new car production. But the bottlenecks are very widespread and there are signs that wages are rising too. The trend towards more trade protectionism and higher minimum wages could reinforce this trend. Finally, high inflation in coming months could un-anchor inflation expectations and set up a higher rate.
Overall, the Fed’s plans make sense, based on what we know now, but the near- term risk is probably for a delay to tapering and the greater longer term risk is probably the other way, faster rate rises.