On Aug. 18, minutes from a two-day Federal Reserve meeting held in July were released, indicating that the Fed intends to curb its $120 billion a month asset purchase program involving Treasury bonds and mortgage-backed securities before the end of the year. The market expects tapering to begin soon, with inflation soaring and employment data finally showing signs of improvement. However, the Fed did not raise interest rates from near-zero levels.
The Fed wrote:
“Looking ahead, most participants noted that, provided that the economy was to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s “substantial further progress” criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum-employment goal. Various participants commented that economic and financial conditions would likely warrant a reduction in coming months.”
Some members believe that current labor market conditions are not yet close to meeting the Committee's "substantial further progress"standard, thus the appropriate time to begin tapering would be early 2022. According to FactSet, 83% of S&P 500 stocks fell after the release of the minutes of the Federal Reserve’s July meeting, suggesting that investors fear a rate hike could happen sooner than some are planning for.
Interest rate concerns
Fed officials have confirmed on many instances that an interest rate hike will not be in the cards until the end of 2022 and that tapering would only begin when the Fed is confident that the economy has attained maximum employment. Further, the Federal Open Market Committee highlighted that the criteria for increasing interest rates are different from those for reducing asset purchases and that the timing of the rate hike would be determined by the economy's progress. The below excerpt from the Fed minutes provides more insights into the thinking behind recent policy decisions.
“The monthly pace of job gains had picked up, with employment expanding 850,000 in June and with notable increases in the leisure and hospitality sector. Nevertheless, the household survey showed that the unemployment rate remained elevated at 5.9 percent in June, and the labor force participation rate and employment-to-population ratio were little changed in recent months. Participants indicated that the economy had not yet achieved the Committee’s broad-based and inclusive maximum-employment goal. Several participants remarked that the labor market recovery continued to be uneven across demographic and income groups and across sectors.”
Although the economy is recovering and the demand for workers remains strong, labor supply shortages and hiring issues such as companies not being willing to pay a living wage have hampered employment growth. Further, a slowdown in the vaccination process and the increasing number of new infections have forced some states to reinstate mask regulations and social distancing.
On the other hand, some Committee participants said that monetary policies have limited ability to address the labor supply shortages and hiring difficulties that are currently limiting the employment rate, while others commented that the pre-pandemic labor market may not be the best benchmark against which to compare the progress toward its maximum-employment objective given lasting changes to the economy resulting from the virus-induced recession. The job market still has a long way to go before it reaches full employment, and the Fed’s Committee members agreed that it would make sense to wait patiently for the economy to gain more traction before intervening with interest rate decisions.
Notes on inflation
Inflation is rapidly increasing, with the Consumer Price Index showing prices increased 5.4% in June compared to the previous year. Just over a month ago, the Fed raised its inflation expectations for 2021 to 3% from 2.2% in March. While some participants anticipate that greater inflation will be here for the rest of the year, others believe that the increase this year is a temporary phenomenon.
The below excerpt from the Fed minutes highlights the thinking of Committee members.
“The staff’s near-term outlook for inflation was revised up further in response to incoming data, but the staff continued to expect that this year’s rise in inflation would prove to be transitory. The 12-month change in total and core PCE prices was well above 2 percent in May, and available data suggested that PCE price inflation would remain high in June. The staff continued to judge that the surge in demand that had resulted as the economy reopened further had combined with production bottlenecks and supply constraints to boost recent monthly inflation rates. The staff expected the 12-month change in PCE prices to move down gradually over the second part of 2021, reflecting an anticipated moderation in monthly inflation rates and the waning of base effects; even so, PCE price inflation was projected to be running well above 2 percent at the end of the year.”
Going by these observations, it would be reasonable to conclude that policymakers will continue to support economic growth in the foreseeable future, but quantitative easing is likely to end much earlier than previously indicated.
Takeaway
Given how the Fed is setting itself up to bring an end to its asset purchasing program, investors should prepare for increased volatility in capital markets. Investing in the financial services sector, which would be a big winner of interest rate hikes, seems a good strategy to mitigate some of the risks associated with rate hikes. Likewise, the risks associated with investing in companies that have high levels of debt will likely increase going forward.
