BlackRock: Fed puts on buying brake

16 december 2021

Rick Rieder, BlackRock's Chief Investment Officer for Global Bonds, comments below on the Fed's statement on Wednesday.

At last month’s FOMC meeting, the Committee announced a widely anticipated tapering of asset purchases, and now at today’s meeting Federal Reserve policy makers announced the acceleration of that tapering.

Indeed, the reduction in the pace of purchases will now be $ 20 billion/month in U.S. Treasury securities and $ 10 billion/month in Agency mortgage-backed securities, double the amount announced just a month and a half ago. On this accelerated timeline, the last month of net positive purchases would be between mid-February to mid-March 2022.

We’re not overly concerned about the longer-run market reaction to this move, as there is a tremendous amount of yield-seeking capital around the world that will take up the demand for high-quality securities, particularly at modestly higher yield levels, and we would note (as Chair Jerome Powell recently did) that the central bank is still taking an accommodative policy stance, just less so than previously.

We would suggest, however, as we have for many months now, that this is what it looks like when the Fed is running behind the curve and needs to catch up to rapidly changing events on the ground.

As Powell recently recognized (November 30), 'the economy is very strong and inflationary pressures are high', so it makes sense to finish the tapering of asset purchases more rapidly, which will of course provide the central bank with more optionality should it need to hike rates sooner than previously anticipated.

And indeed, when we look at the Committee’s own Summary of Economic Projections the median expectation suggests three policy rate hikes (of a quarter point each) in 2022, as the Fed begins to normalize rate policy and reacts to high levels of inflation.

Additionally, now that quantitative easing is being wound down more quickly, and the first policy rate increases are on the horizon, the ‘topic of greatest consternation’ will turn to the potential for balance sheet runoff. Chair Powell said that the balance sheet was a topic of discussion at the December meeting, and that discussions would continue at upcoming meetings.

He said that the Committee noted that this is a different situation to previous cycles and the Committee has not made any decisions about when runoff could potentially start. Generally speaking, the consensus of market participants doesn’t expect balance sheet runoff to occur before 2024 and while we would suggest that might be a bit far off, we believe it would be low odds for starting runoff in 2022, although it is likely that we see a good deal more discussion on the topic over the next several months.

The accelerated pace of QE tapering, the potential for policy rate hikes by mid-2022 and the start of some discussions of balance sheet runoff all represent a Fed that is racing to catch up from being behind the curve. What policy makers are racing to catch up with is an economic environment that has displayed remarkable resilience and strength this year.

Take the labor market, where on a non-seasonally adjusted basis payroll data suggests that well over 700k employees are being added to payrolls each month (on average, over the last 10 months), which is much stronger than the reported headline figures. Further, aggregate income has vaulted higher in the past two years, and we know that consumption tracks closely with income.

Remarkably, though, while consumption has ramped up sharply since February 2020, U.S. consumers have actually underspent their 'normal income', which is to say that they’ve been building savings, which represents potential future consumption.

Overall, strong economic growth, labor market recovery and elevated inflation clearly have moved the Fed toward an accelerated focus on shifting policy and particularly in getting quantitative easing over with. We think that shift is long overdue, and clearly it will also provide the Fed with much needed optionality for moving interest rates higher relative to what is likely to be persistently high levels of demand and still strong inflation prints in the first few months of next year.

In our view, today represented a clarifying moment for U.S. monetary policy evolution. Indeed, the Fed previously described how it would be willing to overshoot its inflation target and it did that.

Yet we think now the central bank has also come to recognize that it may have gotten more than it bargained for, particularly given that some of this inflation has been driven by supply shortages and an explosive demand for goods that hasn’t been seen in years, on the backside of a population forced to work from home for an extended period of time. That demand for goods has presented the Fed (and the population at large) with an intimidating near-term set of readings on cost pressures for the broad economy.

Some of that will abate over the coming months, and hence we think this Fed will move very far down the road back to 'data dependency', to evaluate how aggressively it needs to move rate policy quicker toward more normalized levels (and then perhaps consider the balance sheet).

Thus, we’ll be watching the data very carefully in the months to come, as will the Fed, to attempt to better understand how policy will react to this remarkably fluid economic world we live in. Bringing back 'data-dependent' and retiring 'transitory', as well as policy on autopilot is a welcome and healthy transition. Sometimes autopilot can be the wrong way to fly a plane, which for example should begin a gentle and soft landing.

However, a hard brake can also be a scary execution, which we think this Fed will be sensitive to avoiding, and thus investors and policy makers should closely study all the data in the hopes of a gentle reversion to normal demand and pricing pressures in the hopes that pandemic-driven influences will be permanently in the rear-view mirror.