Fed torn between Delta variant concerns and sharp rises in house prices

Our base case is that QE tapering will start in January, but that the Fed will be happy to stay ‘behind the curve’ on inflation.

Thomas Costerg, Pictet Wealth Management

Fed torn between Delta variant concerns and sharp rises in house prices

At its regular policy meeting next week, Federal Reserve Chairman Jerome Powell is likely to repeat that a reduction in the Fed’s monthly bond purchases (currently USD120bn/month) is still “ways off”.

While the spread of the Delta coronavirus variant could be a worry, the sharp rise in house prices (fuelled by very accommodative financial conditions) will likely keep the Fed’s plans for a QE taper on track.

All in all, we believe the Fed will start signalling tapering at Jackson Hole at the end of August, with an official announcement in December and a formal start to tapering in January, although it could start a few weeks earlier. The reductions in asset purchases will be in increments of USD10 bn per month, in our view, which means that the winding down of the Fed’s asset purchases will last throughout 2022. We think the first reduction will fall equally on mortgage-backed securities and US Treasuries. We interpret tapering as a move by the Fed to become less accommodative, but not an actual tightening of its monetary policy.

We believe the Fed will continue to look past headline inflation prints above 2% for several months and to focus instead on labour-market signals before it starts to consider hiking interest rates. This means waiting until the end of 2023, as long as the labour market is functioning to the Fed’s satisfaction at that stage. In other words, we continue to think the Fed will remain growth and market friendly and ‘behind the curve’ when it comes to inflation. In short, we expect a first rate hike by December 2023, followed by further, very gradual, and mostly symbolic rate increases. We continue to think the Fed will leave its benchmark interest rates below its 2% inflation target in the coming years.

Our Fed view is still posited on our belief that there are immense political and financial-market barriers to true monetary tightening (in other words, inflation-adjusted interest rates that turn positive). We think the Federal Reserve will continue to ignore the potential negative side-effects of constant policy accommodation. In fact, we think the Fed could even envisage new ways to stay accommodative and keep easy money flowing into the US financial system. For example, work on a digital currency could put money directly into consumers’ pockets.

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