Full Taper Ahead?

The Federal Open Market Committee concludes a two-day meeting tomorrow. At the top of the agenda will have been a debate over when and how quickly to begin pulling back on the monetary stimulus that has underpinned markets and the economic recovery since the early months of the Covid-19 pandemic.

Since March 2020, the Federal Reserve has held its target benchmark interest rate range at 0.00% to 0.25% and has been purchasing a combined $120 billion a month of U.S. Treasuries and mortgage-backed securities. That has helped lower borrowing costs for consumers and businesses, increase liquidity in markets, and stave off what could have been a much worse financial crisis last year.

Officials won't lift that unprecedented monetary stimulus nearly as quickly as they put it in place. Instead, gradually slowing the pace of monthly asset purchases should come first, a process that could take many months or quarters to complete—hence the term "tapering" that has been so often repeated of late. That's before actually reducing the asset holdings on the Fed's balance sheet. Interest rate increases are even further off. All of those moves will be well-telegraphed in advance, and tomorrow could be the first step on a long, long road of unwinding that stimulus.

Here's Anwiti Bahuguna, Head of Multi-Asset Portfolios at Columbia Threadneedle Investments, writing today:

They’ve been signaling their intention to taper for a while now. The market shouldn’t be too surprised if we hear this week that they plan to start in November or December. One or two months shouldn’t make much difference in terms of market reaction. The announcement of their intention to taper should not be a market moving event. The pace of tapering would be of great interest. Some members had been pushing for a faster unwind to finish by midyear next year while some prefer to take a slower approach. Unlikely that they announce the pace Wednesday, but this would be of interest as it sets up the rate hike path for next year or 2023.

Fed watchers and investors know that interest rate increases are off the table until the tapering process is done. So the faster the taper, the sooner the first rate rise could come, the thinking goes. 

Powell and the FOMC could also easily leave the entire matter to their next meeting this fall. The uncertainty over spending in Washington, a weak August jobs report, and the Delta variant's uncertain economic impact could all be considered cover to sit and wait another six weeks.

But we'll still get more insight into Fed officials' long-term thinking, with an updated Summary of Economic Projections reaching all the way out until 2024. Since the FOMC's latest forecasts in June, those will likely include a lower GDP growth forecast for 2021 thanks to Delta and persistent supply chain bottlenecks, but could call for faster growth in 2022 and 2023. Estimated inflation should rise for 2021, and whether or not it changes in later years will be an indicator of how convinced officials remain about "transitory" inflation. The FOMC’s unemployment projections will probably change the least.

The "Dot Plot" of where officials think interest rates will be in the future could get much more attention tomorrow. Back in June, 7 out of 18 FOMC members saw at least one quarter-point rate increase in 2022, with the median calling for two in 2023.

A signal of sooner or larger increases in 2023 will be seen as a hawkish move by the FOMC. That could lift medium- and long-term Treasury yields tomorrow much more than any tapering announcement would.

Tapering or not tapering will get most of the headlines tomorrow. But investors should keep just as close an eye on the dots.