FOMC preview: Can the Fed avoid spooking markets as it readies a taper?

·3 min read

Federal Reserve Chairman Jerome Powell has all but announced that the central bank will take the first steps in paring back its extraordinary monetary stimulus, hoping that markets will not sour in response.

Commentary from Fed officials over the last few weeks have pointed to an announcement on Nov. 3 that the central bank will slow its quantitative easing program.

For months, markets have been wondering when the Fed would “taper” the pace of its U.S. Treasuries and agency mortgage-backed securities purchases, which the Fed is currently absorbing at a pace of about $120 billion a month.

Hotter-than-expected prints on inflation have tilted policymakers toward taking the Fed’s foot off of the acceleration pedal. Even though Fed officials have emphasized the need to close the jobs shortfall of 5 million workers, policymakers have insisted that near-zero interest rates should still support employment as it tapers.

“I do think it’s time to taper, and I don’t think it’s time to raise rates,” Powell said on Oct. 22.

The central bank has been extremely careful not to rock the boat as it prepares to pull back on its tools. Slowing bond and securities purchases are not a direct link to the more powerful tool of raising interest rates, but markets are already reading the tea leaves on tapering to price in expectations for eventual rate hikes.

Some Fed officials are already signaling that their attention has shifted to rates.

“If we are still seeing 4% inflation or in that area next spring, then I think we might have to reassess the speed with which we would be thinking about raising interest rates,” Fed Governor Randal Quarles said on Oct. 20.

Watch bond yields

Actions by other central banks serve as a cautionary tale of the volatility introduced by a pivot in policy.

At the Bank of Canada, the announcement of an abrupt stop on its asset purchase program jolted investors on Oct. 27, who dumped Canadian bonds and sent government bond yields higher.

Yields stateside have already shown some sensitivity over recent trading sessions. Longer-dated bond yields, such as the 10-year (^TNX) and the 30-year (^TYX), have had days where yields would swing five or so basis points in either direction.

On the short end of the curve, the two-year U.S. Treasury has ripped higher over just the last month, reflecting expectations for the Fed to raise rates roughly twice through 2023. The policy-setting Federal Open Market Committee, 18 members deep, was split 50-50 as of September as to whether or not it could see the first rate hike happening next year.

The FOMC's updated Summary of Economic Projections show the 18-member committee evenly split on whether or not they should start hiking rates next year. Source: Federal Reserve
The FOMC's updated Summary of Economic Projections show the 18-member committee evenly split on whether or not they should start hiking rates next year. Source: Federal Reserve

“Everybody is trying to put forward their best guess in terms of what’s going to happen and when it’s going to happen,” RiverFront Investment Group's Rebecca Felton told Yahoo Finance on Oct. 28. “Until that is out there, you’re going to see these yields continue to fluctuate.”

For his part, Powell has declared victory on its messaging to markets — at least on tapering.

“I think the market generally understands where we are,” Powell said on Oct. 22.

The question is if the markets understand where the Fed is on future rate hikes. The FOMC will convene on Nov. 2 with its policy statement expected on Nov. 3.

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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