Fed Watch: Still Plenty of Punch to Go Around This Holiday Season
4 minute read time
Investors are wondering if stubbornly high inflation will force the Fed to accelerate its plans for tapering asset purchases and raising interest rates. While this is possible, it’s important to understand that accommodative monetary policy is unlikely to go away anytime soon.
The Fed & the Punchbowl
This past weekend I attended my nephew’s wedding in Palm Springs. It couldn’t have gone better for the bride and groom, with robin’s-egg blue skies and majestic mountains serving as the backdrop to their vows. The ceremony had been delayed for over a year due to the pandemic, so the champagne tasted sweeter knowing what we had all been through.
None of us wanted the party to end but, knowing I had to be back at work on Monday, my thoughts turned to the markets and the extraordinary party investors have enjoyed since the Fed unleashed unprecedented stimulus in response to the COVID-induced shutdown.
With the Fed recently announcing that it would begin to reduce this stimulus by tapering its monthly purchases of Treasuries and mortgage-backed securities, I thought of the famous “punchbowl” metaphor, attributed to William McChesney Martin, the Fed chairman from 1951-70. The Fed’s role, Martin said, was to act as a “chaperone who has ordered the punchbowl removed just when the party was really warming up.”
With surging equity markets, a tight labor market, and five straight months of inflation above 5%, a growing chorus is calling on the Fed to start pulling away the punchbowl of easy policy. Former Treasury secretary Larry Summers has been particularly vocal, writing in the Washington Post that “the Fed should signal that the primary risk is [the economy] overheating and accelerate tapering of its asset purchases.”
So, will current Fed chair Jerome Powell listen to Summers’ advice and take away the punchbowl? I wouldn’t bet on it for several reasons. First, it’s important to understand that tapering the balance sheet isn’t the same as tightening monetary policy. As the chart below shows, the Federal Reserve’s balance sheet has ballooned to over $8 trillion dollars since the start of the pandemic. By reducing, or tapering, its asset purchases beginning this month, the Fed will only begin slowing the growth of its balance sheet, not shrinking it.
Source: JP Morgan Guide To The Markets
Indeed, by next June, the Fed's balance sheet is projected to reach $9 trillion. Most of that is made up of bonds associated with the multiple rounds of QE dating back to the financial crisis. When these bonds mature, the Fed will continue to reinvest the proceeds, maintaining a heavy hand supporting market liquidity and keeping a lid on bond yields.
Second, the Fed still believes that much of the inflation we are seeing will fade as bottlenecks are resolved and supply catches up to demand. Raising rates now would risk curtailing demand just as supply comes online, risking a recession.
Third, the Fed has signaled it is willing to tolerate higher-than-average inflation for a period to counteract periods of low inflation such as those that prevailed over the past decade. For now, this “average inflation targeting” framework means maintaining a “wait and see” approach versus preemptive policy action.
Continued Support For Risk Assets
Investors currently anticipate the Fed will finish tapering its asset purchases by June of next year, then raise rates twice in 2022. The Fed itself currently expects only one hike in 2022 and has not even hinted at reducing its balance sheet.
Further, long-term Treasury yields have largely been unfazed by the recent inflation numbers, suggesting that aging global populations, deflationary advances in technology, and foreign demand are at present more powerful than inflation fears.
What this means for investors is that there is plenty of punch to go around this holiday season, and risk assets are likely to continue to benefit. We continue to overweight equities and corporate bonds in client portfolios and recommend considering exposure to complements such as real estate and real assets while keeping cash at a minimum.
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