Fed signals taper to start ‘soon’

Chris Scicluna
Emily Nicol

Fed signals taper to start ‘soon’ and end by mid-2022; possible rate hike to follow later in 2022 as inflation forecasts raised and risks still skewed heavily to the upside
The key event over the past 24 hours – albeit eliciting little market reaction – was the Fed’s FOMC policy announcement, revised economic and policy projections and Chair Powell’s post-meeting press conference. As expected, the committee held the target fed funds rate at 0-¼%. The interest rate on required and excess reserves was also unchanged at 0.15%. However, the Fed did double the counterparty limit on reverse repurchase agreements to $160bn per day. This will allow for a larger drainage of reserves from the banking system, and so relieve downward pressure on short-term interest rates.

The post-meeting statement contained only a small number of changes from that issued after the 28 July meeting. Of greatest near-term importance was the alteration of text relating to the prospective QE taper. This now reads, “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” Chair Powell was more forthright in his subsequent press briefing, noting that in his mind the criteria for tapering had all but been met and that the decision to commence could come as soon as the next FOMC meeting on 3 November, provided that the October employment report delivers “decent” results. Indeed, Daiwa America’s Chief Economist Mike Moran now expects a taper announcement at the 3 November meeting, with the process to begin in December. During the briefing, Powell also indicated that the tapering process would probably end by the middle of next year. When asked, he gave no guidance about possible security sales or redemptions once tapering is completed. However, it is worth recalling that after the financial crisis, the Fed did not begin redeeming securities for three years after it ended purchases.

The other changes to the post-meeting statement concerned the economy. Regarding activity, while the sectors most affected by the pandemic had continued to improve, the statement noted that the recent rise in virus cases had slowed their recovery. Regarding prices, the statement now notes that inflation is “elevated”, while continuing to express an opinion that this state is transitory. The updated Summary of Economic Projections reflects these changes. Consistent with recent signs of a slight decline in economic momentum, the median participant expects GDP growth of 5.9% this year, down from 7.0% previously. About half of that downward revision is unwound with upward revisions to projected growth in the following two years. And so while the unemployment rate is now expected to end this year at 4.8% – 0.3ppt higher than previously projected – the forecast for the subsequent years is unrevised, still reaching a low-point of 3.5% in 2023 (0.5ppt below the assumed long-run level).

Reflecting past inflation outcomes and an expectation that supply bottlenecks will be slower to clear than thought previously, the median participant’s forecast for inflation has increased across the projection. The forecast for core inflation this year was lifted by 0.7ppt to 3.7%, while that for the following two years was raised by 0.2ppt and 0.1ppt to 2.3% and 2.2% respectively. The first forecast for 2024 projects that core inflation will remain at 2.1%, and thus above the Fed’s medium-term target. Importantly, as was the case previously, 13 of the 18 participants view the risks to core inflation as weighted to the upside, with the remaining five participants viewing the risks as broadly balanced and nobody assessing the risks as weighted to the downside. The stronger outlook for inflation has driven changes to some participants’ outlook for the federal funds rate. Nine of the 18 participants now expect a first rate hike next year – up from seven previously – with three of those nine expecting two rate hikes. All but one participant expects lift-off to have begun by the end of 2023. While half of respondents still expect a first rate hike beyond next year, the Fed’s summary table characterises the median projection in 2022 as 0.3% (0.2ppt higher than previously), while the forecast for 2023 was raised to 1.0% (up from 0.6% previously). The first forecast for 2024 envisages a year-end fed funds rate of 1.8% – still below the assumed long-run rate of 2.5%.

Wall Street rallies as China Evergrande worries ease somewhat, with no enduring stock or bond market reaction to the Fed; Japan closed today, but other Asian equity markets rally
With concerns about possible contagion risks stemming from China Evergrande’s troubles easing, Wall Street went into the Fed meeting on the front foot with the S&P500 up around 1%. And following a few minor post-Fed gyrations, that is where the index closed, thus erasing about a third of the decline seen over the previous four sessions. With Treasury yields having already trended modestly higher of late as investors seemingly positioned for a slightly more hawkish Fed, the bond market reaction to the Fed’s latest prognostication was muted. Indeed, the 10Y note closed at a yield of 1.30% – just 1bp below pre-Fed levels and down 2bp for the session. Following some initial volatility, the greenback stabilised slightly above its pre-Fed levels.

Since the close, US equity futures have firmed a couple of tenths. With Japanese markets closed for a national holiday, cash Treasuries did not trade in Asia but futures have softened just a little. With the exception of South Korea – where equity markets have moved a little lower, playing catch-up after a three-day holiday – the tone has been moderately positive across the Asia-Pacific region. Returning from yesterday’s holiday, the Hang Seng initially rallied more than 2%. However, those gains have been pared sharply, with the index currently up just 0.5%, not least due to a near 4% rebound in real estate stocks. Investors were comforted by the provision of further short-term liquidity by the PBoC (via seven- and 14-day reverse repos), while China Evergrande’s stock has rallied about 10% off Tuesday’s all-time low (it had rallied more than 30% at one point and, sadly, remains down 83% for the year to date). Elsewhere, China’s CSI300 has firmed 0.6% and stocks have gained a little more in Singapore.

In Australia, which reported improved September PMI readings today – especially in the manufacturing sector – the ASX200 has rallied just over 1%. However, in keeping with the slight decline in yields in the US, the 10Y AGCB has traded down 2bp to 1.24%. Bond yields also moved slightly lower in New Zealand, where the RBNZ confirmed that it would tighten Loan-to-Value Ratio restrictions on residential mortgage lending from 1 November (formally delayed by one month due to the recent virus outbreak, but with the RBNZ making clear that it expects banks to comply with the spirit of the new rules immediately).

BoE likely to leave policy unchanged while flagging upside risks to inflation
Today the monetary policy focus shifts to the BoE, whose MPC meeting announcements are due at lunchtime. This meeting has taken place against the backdrop of a leap in inflation and expectations of further increases to come due not least to the ongoing spike in natural gas prices, which is more acute than elsewhere in Europe. The BoE should not have been surprised by the jump in both headline and core CPI rates in August to multi-year highs above 3%Y/Y. After all, the largest contributor to the rise was the base effect associated with last year’s hospitality subsidies and VAT cut. And certain other pressures, not least related to used car prices, seem bound to be transitory. But especially due to energy prices, over the near term inflation is likely to exceed the path set out in the BoE’s most recent projection, which foresaw inflation rising slightly above 4.0%Y/Y in Q421 and Q122. And with supply shortages widespread causing production difficulties and empty supermarket shelves, vacancies up to a record high, as well as hints of rising wage settlements, the MPC seems highly likely to flag that the risks to the inflation outlook are skewed to the upside.

At the same time, of course, economic recovery momentum appears to have been levelling off over the summer. UK GDP growth slowed to 0.1%M/M in July, and Friday’s August retail sales release reported the longest unbroken losing streak on the series. Over the near term, there are notable additional downside risks to demand too, including the ending of the job furlough scheme, cuts to universal credit, and pressures on power prices to come. So, the BoE’s near-term GDP forecast now looks overoptimistic and the minutes of this meeting are likely to acknowledge that.

The majority on the MPC will still likely continue to expect inflation to fall back in due course, even if it remains higher for longer than previously expected. Moreover, with risk management considerations also still pertinent, just as early in the last decade when inflation jumped above 5%Y/Y and remained above target for four years, the MPC will not tighten policy precipitously in response to supply-driven price pressures that it suspects have a good chance of being temporary. So, on balance, we continue to expect a large majority of MPC members to vote to leave the Gilt purchase target unchanged at £875bn, with those purchases to be concluded by the end of the year.

Of course, if the MPC wants to send a more hawkish signal, it could vote today to curtail the QE programme early when the Gilt purchases amount to £850bn. External member Michael Saunders – who on his own voted for such a policy last month – is likely to do so again today. And we would not be surprised to see new Chief Economist Huw Pill join him. However, new external member Catherine Mann seems likely to be dovish, and vote with the majority against such a move.

Flash PMIs likely to flag moderation in European growth momentum as supply-side strains continue to bite
Data-wise, the main focus in Europe will be the flash PMIs. While the euro area services activity PMI is expected to have moved broadly sideways, yesterday’s improved flash consumer confidence estimate might point to upside risks thanks to the decline in the spread of the delta variant across the region. But the manufacturing output PMI is expected to fall for a third successive month as the sector continues to be impacted by supply bottlenecks. Overall, the euro area composite output PMI is expected to ease back slightly from the still-elevated reading of 59.0 recorded in August. And the UK’s composite PMI is expected to have slipped back from 54.8 last month to a seven-month low, suggesting that supply constraints are more acute than in the euro area.

Attention turns back to the economic data in the US, with the flash September PMIs and Conference Board leading index leading today’s docket
With the FOMC meeting now out of the way, attention in the US today will turn back to economic data. While less followed than the long-running ISM indexes, the flash Markit PMIs for September will nonetheless be of interest, especially the services PMI after it declined to an eight-month low of 55.1 in August. The Conference Board will release its leading index for August while the Kansas City Fed’s manufacturing survey for September and the weekly jobless claims report are also due.

Manufacturing rebound leads September PMI recovery in Australia
The only economic news in Australia today were the flash Markit PMIs for September. In summary, the data continued to point to a pandemic-induced contraction of activity in Q3, albeit with the composite output index rising 2.7pts to a three-month high of 46.0 (and far below the upbeat 56.7 recorded in June, prior to the Sydney virus outbreak).

The improvement this month owed mostly to the manufacturing sector, with the headline manufacturing PMI rebounding 5.3pts to a very solid 57.3 and the output index recovering an even steeper 7.6pts to 53.3. Perhaps in anticipation of a loosening of lockdown restrictions, the new orders index also rebounded a solid 6.9pts to 53.0, whereas the new export orders index increased just 0.4pts to 50.9. The employment index, which has remained resilient through the recent virus outbreak, increased 1.4pts to 54.2. The improvement in activity carried through to the pricing indicators, with the inputs index rebounding 5.5pts to 79.6 (the highest in the survey’s short five-year history) and the output prices index rising 1.0pts to 62.8 (just below the all-time high recorded in June).

Predictably, conditions remained much less positive in the services sector, although the headline services PMI – the business activity index – did rise 2.0pts to three-month high of 44.9. The new orders index increased a similar 2.1pts to a still contractionary 45.4, but the employment index moved back into expansionary territory with an increase of 3.4pts to 51.9. As in the manufacturing sector the pricing indicators firmed this month, with the input prices index rising 0.5pts to 59.3 and the output prices index increasing 2.0pts to 56.2 – the latter not fall below the record high recorded in June.

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