Fed Research Preview: Tapering, yes, but how fast?
|Key takeaways
We expect the Fed will announce QE tapering at next week’s meeting. We expect the Fed to start tapering immediately in November with a tapering pace of USD15bn per month (completed in June). Risk is tilted towards a higher tapering pace of USD20bn per month.
Fed Chair Jerome Powell sounded more concerned about high inflation on Friday, which we expect him to repeat on Wednesday. We expect Powell to repeat that the tapering decision is not related to a future decision on rate hikes. Still, we expect the rhetoric to be more hawkish than in September.
Please note that the Fed policy announcement is 19:00 CET (as the EU switches to winter time on Saturday). The press conference starts 19:30 CET.
We still expect two rate hikes next year (one in September and one in December).
FX: We continue to forecast EUR/USD to 1.10 in 12M (with downside risks).
Fixed Income: We still see upside for 10Y UST yields. We currently have a 2% target.
Fed call: Tapering pace is the most important factor
Friday last week, Fed Chair Jerome Powell said that he thinks it is time to taper, thus sending a strong signal that the Fed will announce tapering at the upcoming meeting next week, in line with our expectation. This also seems like consensus in markets and among other economists. There are, however, still two things to watch out for. Will the Fed start tapering immediately already from November or wait for December? And how fast will the Fed taper? We expect the Fed to start tapering immediately with a tapering pace of USD15bn per month, implying that the Fed ends tapering in Q2 22, in line with the illustrative path from the last meeting. Risk is tilted toward a faster, not slower, tapering pace of USD20bn per month.
It is one of the interim meetings, so there are no updated projections or dots in connection with the meeting. So all focus is on the press conference. On Friday, Fed Chair Powell sounded more concerned about bottlenecks and inflation, saying that risks are tilted clearly towards prolonged bottlenecks and higher inflation and that the Fed is monitoring inflation carefully. To us, the Fed is likely to make another hawkish shift, although it is more difficult to make a big one at interim meetings (and Powell was out speaking last Friday).
With tapering looming, the next big question is when the Fed will start hiking the Fed funds target range and how much. We recently changed our Fed call now expecting two 25bp rate hikes in September and December 2022 (see Fed Research: Powell likely to remain chair and hike twice next year, 14 October), as the economy should have normalised further by then with higher employment. Labour demand remains high and the labour force remains lower than before COVID-19. Also we expect CPI/PCE core to grow at a pace slightly higher than 2% annualised. Fed already says that the inflation mandate is fulfilled.
We expect, however, Fed Chair Powell will repeat that the tapering decision is not related to the rate hike decision. We do not expect markets to listen a lot to this statement. First of all it is not a new statement and investors have started to price in rate hikes anyway and second of all tapering marks the beginning of policy tightening.
The Fed is likely to remain some flexibility to increase/slow the tapering pace if needed. Also we cannot rule out that the Federal Reserve will be forced to raise rates earlier during tapering if inflation and inflation expectations rise further (or if employment growth accelerates).
Markets are pricing in an 80% probability of a rate hike in June 2022 and a total of slightly more than two rate hikes next year. So markets are slightly more aggressive than us in 2022.
Besides that there are potentially many changes to the Fed in 2022, as President Joe Biden has a lot of important decisions to make in coming months. Not least whether to renominate Powell as Fed chair or not. Our base case is that Biden will re-nominate Powell despite the Fed trading scandal. We discussed in further details in Fed Research: Powell likely to remain chair and hike twice next year, 14 October
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