What’s Next For The Fed?

Now that the Federal Reserve has formally announced its taper plans, what can we expect next?

The Taper

First of all, let’s not go into panic mode because the Fed is suddenly reducing its asset purchases. In the statement following its November 2-3 meeting, the Fed said it would “begin reducing the monthly pace of its net asset purchases by $10 billion for Treasury securities and $5 billion for agency mortgage-backed securities.” In the scheme of Fed purchases, that’s practically nothing, you won’t even feel it. Indeed, in the very next sentence, the Fed also announced the converse of that, namely that starting this month, it “will increase its holdings of Treasury securities by at least $70 billion per month and of agency mortgage-backed securities by at least $35 billion per month. Beginning in December, the Committee will increase its holdings of Treasury securities by at least $60 billion per month and of agency mortgage-backed securities by at least $30 billion per month.”

Note the operative word, Increase. So yes, it’s accurate to say that the Fed is reducing its asset purchases, but it’s not going away, far from it. It’s still buying a ton of securities. Remember that the Fed’s balance sheet currently totals $8.5 trillion and still growing. Now, the Fed did add that “it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook,” which most market participants take to mean that the Fed is more likely to speed up, not slow down, the pace of purchases, given the current robust state of the economy. That’s a good thing and long overdue.

Interest Rates

The Fed also announced that it is keeping the target range for its key interest rate at or near zero for the time being. Fed Chair Powell said no rate increase was likely until after the tapering process had been completed, which appears to be sometime in the spring of next year. It can certainly be argued that the current state of the economy and the elevated rate of inflation should prompt the Fed to start raising interest rates, too. But it probably makes sense to wait until the market first adjusts to less Fed asset buying before hitting it with higher rates. Based on the lack of movement in long-term bond yields, the market doesn’t believe a rate increase is coming anytime soon.

Absent the taper. However, it certainly is time to raise rates. Indeed, in last week’s statement, the Fed finally backed off—a little—in its characterization of inflation. It still insists that rising inflation is “transitory” which few people seem to believe, although now it says it is only “expected to be transitory.” Well, it’s something.

Unwinding The Balance Sheet

While the Fed announced its plans to taper and hinted at when it might start to raise rates, it has said nothing about reducing its mammoth $8.5 trillion balance sheet, which equates to about 20% of U.S. GDP. Remember, following the 2008 financial crisis, the Fed took nearly four years to start reducing its balance sheet, which peaked at what now seems a laughable $4.5 trillion, about half of what is now and during what can be argued a much more serious financial crisis. Over the following two years or so, it reduced that by a modest $800 billion until the summer of 2019, when it reversed course in response to the Covid-19 pandemic and began pumping trillions of dollars more into the economy.

Using the previous crisis as a guide, the Fed probably won’t start unwinding its balance sheet until 2025 at the earliest. Then, if it does start and continues, the unwinding process will go on at the same snail’s pace. As a result, it will take a long time before there is some meaningful reduction in the balance sheet.

Powell’s Reappointment

Last week we also learned that President Biden met separately at the White House with Powell and Fed governor Lael Brainard, Powell’s presumptive successor if Biden decides to dump Powell. If I had to guess which of those he would choose, I would go with Brainard, supposedly the progressives’ favored candidate, although it could be someone else, as I suggested in my previous column.

So far in his presidency, Biden has shown no stomach or backbone for inciting the wrath of the Democrat far left, and that’s exactly what he would face if he renominated Powell, which is why Brainard seems the safer choice from his perspective. Brainard is at least a better-known quantity than the other people I suggested so that the financial markets might be comfortable with her as well. Given Powell’s (so far) wrong assessment on inflation, the recent Fed trading scandal, and his perceived record on bank regulation and climate change, Biden could easily be persuaded to go in another direction.

Biden now has a total of four seats on the Fed board to fill, including Powell’s, following Randal Quarles’ announced intention to resign by yearend. As a result, we can expect big changes in Fed policy next year.

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George Yacik
INO.com Contributor – Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.

Source: https://www.ino.com/blog/2021/11/whats-next-for-the-fed/