Inflation Risks Put the Fed in an Uncomfortable Place

As expected, the U.S. Federal Reserve announced the first reduction in its monthly pace of bond purchases at the November FOMC (Federal Open Market Committee) meeting, while also admitting that the outlook for inflation is more uncertain. Markets responded calmly to the news but looking ahead, Fed policymakers have the tougher task of managing markets’ rate expectations in the face of elevated inflation risks.

While we agree with the Fed that the currently high inflation is likely to dissipate, it now appears that it will take longer to dissipate than initially thought. Inflation that remains elevated for longer, even if it’s attributed to temporary factors, increases the risk that longer-term inflation expectations also adjust higher – something the Fed wants to avoid. Indeed, the next few months are likely to test policymakers’ patience, and we see meaningful risk of Fed officials’ expectations for rate hikes being pulled further forward when the Fed’s next economic projections are released in December.

Long-anticipated tapering is a non-event

The Fed announced its plan for beginning to wind down its purchases of U.S. Treasuries and mortgage-backed securities (MBS). In particular, it announced that it will reduce purchases by $15 billion per month in mid-November and mid-December. And while these monthly reductions are likely to continue through June 2022, the Fed also specifically stated that it is prepared to change the pace of monthly reductions if economic conditions warrant. After the Fed ends these secondary market purchases, we expect it will keep its balance sheet static by continuing to roll over its maturing proceeds at Treasury auctions or back into the MBS market, respectively.

Elsewhere, the FOMC made only minor changes to the statement to acknowledge that economic activity has started to rebound from the summer soft patch, and that inflation, while still “expected” to be transitory, has remained elevated as supply and demand imbalances related to the pandemic contributed to “sizable” price increases in some sectors. Meanwhile, during the press conference, Fed Chair Jerome Powell continued to assert that inflation is likely to be transitory, but he also emphasized the Fed’s willingness and ability to act to tame inflation if needed.