Inside the Broker - The Federal Reserve edges closer to tapering
Inside the Broker
The Federal Reserve edges closer to tapering
We’re in the heart of the summer and the second quarter earnings season is winding down with just the bricks and mortar retailers to report this week. It has been a positive one. According to FactSet, second quarter revenue growth is on target to be the highest since 2008 when the data analysts began tracking the numbers. In addition, so far 87% of S&P 500 companies have reported better-than-expected earnings. If this continues, it would also be a record breaker. Of course, the year-on-year comparisons flatter this year’s results due to poor numbers during the pandemic. Nevertheless, it helps to explain the ongoing strength of US equities.
Tapering bond purchases
Currently, market-related discussion focuses on when the US Federal Reserve, the world’s most influential central bank, will begin to wind down its monetary stimulus. It’s proving quite difficult to do. Quantitative easing from the US central bank goes back to the Great Financial crisis of 2008/9. The Fed, along with other central banks, slashed borrowing costs and hoovered up government bonds, mortgage-backed securities, and other financial assets to steady markets in the wake of the mortgage bust which devastated the global economy. Before that crisis, the Federal Reserve’s balance sheet hovered around $800 billion or so. Then it rose from $900 billion in August 2008, to 2.25 trillion four months later. Six years on it had grown to $4.5 trillion despite an attempt to reduce it under Fed Chair Ben Bernanke. This ended before it could start due to a negative reaction from the bond market.
Eventually the US central bank, under the leadership of Janet Yellen, managed to hike interest rates five times, starting in December 2015. Controversially, these rate hikes were carried out while the Fed’s balance sheet was also being reduced. Her term ended in February 2018 after President Trump refused to reappoint her. Jerome Powell succeeded her, and a sixth rate-hike was planned for the March 2018 meeting, much to Trump’s displeasure. But by the third quarter of 2018 investors made it clear that they had had enough and expressed their views by dumping equities, sending the S&P 500 down over 20% in the space of three months. This proved sufficient for Jerome Powell to reverse course. This left the balance sheet at over $4 trillion and the Fed funds rate at 1.75%, down from 2.5% in early summer.
Then the coronavirus shook up the world. The Fed slashed its key interest rate below 0.25%, to where it is now, while its balance sheet now stands at over $8 trillion. So much for ‘temporary’. But there must come a time when the Federal Reserve has another go at rolling back its monetary stimulus, and the question is ‘when’? There’s this general feeling that the Fed is scared stiff of tightening monetary policy due to the high levels of debt that have been accumulated around the developed world. But as we can see from above, Janet Yellen, who is now Treasury Secretary in the Biden administration, is no stranger to rate hikes. In fact, earlier this summer she said: “We’ve been fighting inflation that’s too low and interest rates that are too low now for a decade. We want them to go back to ‘a normal interest rate environment’ and if this helps a little bit to alleviate things then that’s not a bad thing – that’s a good thing.” This is good news for Jerome Powell who now has political backing for tightening monetary policy.
You’re on your own
The Fed may have support from the Biden administration, but they’re on their own when it comes to the timing as well as taking flak for any market fallout. There are two main factors that the Federal Reserve is watching: jobs and inflation. These are the elements of its ‘dual mandate’ – ensuring price stability (controlling inflation) while maximising employment. Now inflation as measured by CPI is currently over 5%, way above the Fed’s 2% target rate. But the central bank is prepared to let this run hot without raising interest rates. Firstly, since the financial crisis, inflation has run below target for much longer than it has been above. Secondly, the Fed wants to see some inflation as it helps erode debt. Lastly, the Fed believes this current lift in inflation is ‘transitory’, as it is due to a surge in post-pandemic economic activity, and the year-on-year comparisons are with pandemic levels when we saw deflation. They could be proved wrong on this. While last week’s CPI numbers suggest they’re correct, the PPI data indicate otherwise. So, the jury’s out.
What about employment? Earlier this month we saw the latest Non-Farm Payroll update which was much better than expected. It is evidence of progress in the jobs numbers which the Federal Reserve has emphasised as paramount to justify tapering its bond purchase programme. This is seen as a precursor to raising its key Fed Funds interest rate from its current level below 0.25%, where it has stood since March last year. But there’s still a shortfall of around 5.5 million jobs to get back to pre-pandemic employment levels which the Fed has said it wants to do. This could still take some time. It also gives the Fed the necessary cover to delay tightening monetary policy, should they need it.
When and what?
But recent comments from members of the Federal Reserve suggest that tapering is coming soon. When is an announcement most likely to come? The earliest would be at the Jackson Hole Economic Symposium at the end of this month. But it’s not the ideal forum, and the Federal Reserve’s monetary policy meeting which ends on 22nd September seems a more likely prospect. So, what could that mean for financial markets? There’s been a growing concern that equity and bond markets will slump without continued support from the Federal Reserve. But it’s worth remembering that the markets rallied strongly from early 2016 to September 2018 when the Fed last tightened monetary policy. And this time round, there’s plenty of government intervention as well, with the Biden administration trying to push through several fiscal stimulus packages worth around $6 trillion. Maybe it will be ok.