Here’s why you should care the Fed is set to announce it’s tapering its bond-buying stimulus
The Federal Reserve, in a sign of how far the U.S. economy has recovered from the COVID-19 recession, is expected to announce this week that it will begin scaling back the bond-buying stimulus it began in the early days of the health crisis.
Although that milestone will come as no surprise, the Fed could reveal the approach it’s taking to a recovery that suddenly has become more complicated, with inflation picking up just as growth is slowing.
Normally, economic growth and inflation move together. The Fed lowers interest rates to stimulate borrowing and jump-start economic activity and raises them to curtail growth and head off a spike in inflation.
The Fed isn’t expected to raise its key short-term interest rate from near zero at a two-day meeting that starts Tuesday, or anytime soon.
But if Fed policymakers lay out a plan to reduce the bond buying more rapidly than anticipated, it likely will be viewed as a signal they could hike rates earlier and faster than projected next year to rein in a surge in consumer prices.
“Markets are betting the Fed will raise rates more quickly,” says Kathy Bostjancic, chief U.S. financial economist for Oxford Economics.
Aggressive rate increases would mean higher borrowing costs for consumers on everything from mortgages and car loans to credit card bills.
‘Substantial’ strides to full employment
The central bank has been buying $80 billion a month in Treasury bonds and $40 billion in mortgage-backed securities to hold down long-term rates, such as for mortgages, and spur more economic activity.
It has said it will continue the purchases at that pace “until substantial further progress has been made toward” its goals of full employment and 2% inflation.
Full employment occurs when virtually every able bodied person who is willing to work at the prevailing rate of wages is working.
Fed Chair Jerome Powell has said the inflation target already has been met – prices rose 4.4% annually in September, according to the Fed’s preferred measure – and progress has been made toward full employment.
The unemployment rate has fallen to 4.8% from 6.7% in December, though that’s still well above the pre-pandemic level of 3.5%, which marked a half-century low.
Fed officials have suggested they’ll likely taper down the Treasury and mortgage bond purchases by $10 billion and $5 billion, respectively, each month, starting in November. Under that scenario, the bond buying would end next June.
The announcement of the tapering itself isn’t expected to push up interest rates, which already have risen in anticipation of the move as well as higher inflation, Bostjancic says. Since late last year, 10-year Treasury yields have climbed from 0.93% to 1.56% and the average 30-year fixed mortgage rate has increased from 2.74% to 3.14%.
Low mortgage rates have helped home buyers across the country as prices have continued to rise with a shrinking supply of homes.
Higher bar for rate hikes
By contrast, the central bank has said it will keep its key interest rate near zero until the economy actually returns to full employment and inflation has risen above its 2% goal “for some time.”
Fed Chair Jerome Powell has stressed that’s a higher bar than what’s required to wind down the bond buying, and the end of bond purchases doesn’t mean the start of rate hikes.
He also has said the Fed is unlikely to nudge rates higher while it’s still snapping up bonds to juice the economy.
Investors don’t seem to be buying Powell’s efforts to totally separate the bond program from rate increases. Fed funds futures markets are predicting two rate hikes next year and as many as three in 2023. In September, Fed policymakers predicted no more than one rate increase next year.
Inflation surge
Markets are reacting to a leap in inflation triggered largely by the reopening economy and COVID-related supply-chain bottlenecks that have led to myriad product shortages.
Powell and other Fed officials have said they believe the sharp price gains are temporary, noting they’ve been driven by higher costs for goods and services affected by the pandemic, such as airfares, hotel rates and used cars.
But the most recent consumer price index showed inflation has spread to a broader range of items, especially rent, food and energy.
The average price for a gallon of regular unleaded gas in the U.S. has increased by $1.25 to $3.40 compared to one year ago, according to AAA. In California, the average price of unleaded gas is $4.59 a gallon.
“The supply-side constraints have actually gotten worse in some respects,” Powell said during a recent virtual conference. ” The risks are clearly now to longer and more permanent constraints and thus higher inflation.”
In a post-meeting statement, the Fed isn’t expected to change its view that the inflation bump largely reflects “transitory factors.” Such a change would raise alarm bells and signal an inclination to faster rate increases, Bostjancic says.
But Morgan Stanley believes the Fed will add that the supply snags “may keep inflation elevated well into next year.”
Bond stimulus could be cut faster
Economists also don’t expect the Fed to veer from its plan to trim the bond purchases by a total $15 billion each month.
Barclays, however, thinks the Fed will add that the tapering “is not on a preset course,” suggesting it could be accelerated if supply kinks linger and inflation proves more stubborn.
That’s simply “boilerplate” language, Barclays says.
But Bostjancic says it may make already-jittery investors more nervous, potentially pushing market-based interest rates higher and dinging stock prices. It would be less disruptive if Powell simply notes the Fed’s flexibility to adjust the bond purchases during his news conference, she says.
If the supply snags and inflation don’t ease noticeably by the middle of next year, as many economists expect, the Fed then could simply scale back the bond purchases more rapidly and shift to rate hikes shortly after, Bostjancic says.
After all, she says, since rate hikes and cuts work with a lag, the Fed also could make a mistake by raising rates too early — just before the supply problems ease and prices fall. That could push down inflation too sharply and hinder an economy that’s already projected to slow next year.
This article originally appeared on USA TODAY: Fed tapering: Central bank is set to reduce bond-buying stimulus
