Fed Tapering Coming Soon; Dots Plot Has Thickened

As we expected, the Federal Open Market Committee (FOMC) did not lift the fed funds rate, but its statement confirmed that tapering is coming soon—although no precise details on timing or pace were announced. The decision was unanimous. The key new sentence in the statement read: “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” That was changed from July’s statement: “…the Committee will continue to assess progress in coming meetings.” The statement also explicitly mentioned the delta variant’s impact on “sectors most adversely affected,” noting that “the rise in COVID-19 cases has slowed their recovery.”

The step toward tapering is consistent with the Fed’s assertion that since July, when inflation had “risen,” inflation is now “elevated.” The “may soon be warranted” language in the statement squares with our view that an official announcement, with details, is likely at the next FOMC meeting in early November—barring a significant deterioration in labor market or broader economic data. Importantly, the Fed has been consistent in telling markets that rate hikes will not commence until tapering is fully complete.

Separately, the Fed decided to double the size of counterparty limits on its reverse repo facility from $80 billion to $160 billion per counterparty. As per Bloomberg, “it will provide some additional breathing room for short-end rate markets as the pressures around the T-bill market imbalance, Treasury’s dwindling cash pile and the debt ceiling conundrum continue to rattle on.”

Update to SEP

Each of the calendar quarter end FOMC meetings bring an update to the Fed’s Summary of Economic Projections (SEP), seen below. Notable is that the real gross domestic product (GDP) projection for this year was revised down sharply since June, from 7% to 5.9%; although next year’s projection was upped to 3.8% from 3.3%. Presumably, this reflects a view that pandemic-related supply chain disruptions will ease; with room for output to expand again thereafter.

The Fed’s unemployment rate projection was raised for this year from 4.5% to 4.8%; before an expected (and unchanged) retreat to 3.5% in 2023/2024. In sharp focus were the higher inflation projections, with an upgrade to headline PCE from 3.4% to 4.2% this year, settling back to 2.2% in 2022 and 2023. Even with the higher projections, a record number of FOMC members still see inflation risk to the upside. This was also the first time projections for 2024 were published.

Source: Charles Schwab, Federal Reserve, as of 9/22/2021. Note: Projections of change in real gross domestic product (GDP) and projections for both measures of inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal consumption expenditures (PCE) and the price index for PCE excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated. Each participant’s projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. The projections for the federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. ¹For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. ²Longer-run projections for core PCE inflation are not collected.

Dots plot thickens

The dots plot, also released four times per year, shows policymakers’ expectations for where short-term interest rates may be headed in the future. The dots are never labeled with the submitting members’ names; leaving the game of “pin the dot on the member” to be played by Fed watchers.

As shown below, the current plot highlights a lack of consensus with regard to the outlook; with nine of the 18 members expecting a rate hike in 2022; while the majority see three rate hikes in 2023. The new 2024 projections show continued hiking taking the median fed funds rate to 1.8%, which is higher than what the markets have been discounting. That said, crucial to understand is that these dots have historically been notoriously inaccurate; not to mention the fact that some of the FOMC members tied to these dots will be termed out by 2023.

Presser

As usual, this report gets submitted for publishing about 30 minutes into the post-meeting press conference; so it may not include snippets from the latter part. Highlights from the first half hour:

• Powell said that “substantial further progress” on employment could mean that the unemployment rate is about half-way toward estimates of the “natural rate,” vs. where it was in December last year.
• Powell expressed a view that certain supply bottlenecks may be around into next year; reflected in the higher inflation projections in the SEP.
• Powell said that the tapering process could end sometime in mid-2022, with most FOMC members favoring a gradual pace—commensurate with the view that a November announcement would be followed by an eight month (give or take) tapering process.
• Powell was asked about the controversy surrounding the trading activities of regional Fed presidents Robert Kaplan (Dallas) and Eric Rosengren (Boston), and his response was that he was not aware—but that the Fed “Board will review the rules around trading and asset holdings for reserve bank presidents.”

In sum

There was limited reaction in markets to the news today. The overall tone of the statement, SEP and dots plot leans more hawkish than what the markets had been pricing in, which helps explain the mild tick higher in the 10-year yield following the announcement. From a very loose range, we expect financial conditions to begin tightening, which could have more impact on asset prices than simple rate moves.