The ‘Old’ New Fed, an Accelerated Taper and a Heavily Mutated COVID-19 Variant
Well, that was an unusually busy Thanksgiving break. In this article, we catch you up on major developments—from Jerome Powell’s renomination as chair of the Federal Reserve Board, to the risks of an accelerated taper and the omicron COVID-19 variant.
What does Powell’s renomination mean for markets?
On Nov. 22, U.S. President Joe Biden nominated Jerome Powell to serve another four-year term as Fed chair. With John Williams as president of the Federal Reserve Bank of New York and the elevation of Lael Brainard to the post of vice chair, investors got an important message of stability at the top of the U.S. central bank. We believe that Powell’s adept handling of the COVID crisis and ability to work across a polarized U.S. Congress during stress periods are important positives for investors.
Markets did express some anxiety that Powell might be more hawkish on interest rates than Lael Brainard (the other leading contender for the job), but in our view, those concerns are overstated. Both Powell and Brainard are dovish, both strive for a full and inclusive labor market recovery and both supported the Fed’s new monetary policy strategy, which allows for temporary inflation overshoots. Our estimation is that Powell and Brainard’s interest rate views probably only differ by about 25 basis points through the end of 2023 which is, frankly, a rounding error given the considerable uncertainty surrounding macroeconomic forecasts that far into the future. Stability is the main takeaway here and that is a positive for markets.
Adieu, transitory: Powell retires term used to characterize inflation
Powell’s testimony in front of the U.S. Congress this week was more concerning. On Nov. 30, he announced that the Fed is retiring the use of the word transitory to characterize U.S. inflation, discussed growing risks to the Fed’s price stability mandate and flagged (three times) that the committee would discuss an acceleration of its tapering program at the upcoming December FOMC (Federal Open Market Committee) meeting.
The fact that Powell retired the term transitory was mostly just a matter of semantics. This inflation overshoot has clearly been larger than expected and longer lasting than expected. Nevertheless, Powell, the Fed staff, our strategist team at Russell Investments and most professional economists still expect inflation to step down markedly in the second half of 2022. Pick your own new adjective for that. Perhaps it’s the phrase not permanent—oh wait, that’s what transitory means!
Will the Fed speed up its tapering of asset purchases?
Of more consequence for markets was the guidance from Powell that the Fed might accelerate the tapering of its asset purchases at the December meeting. This did not come out of right field—the idea has been discussed by other FOMC members like Richard Clarida, Christopher Waller and Mary Daly in recent weeks. But Powell’s conviction around the issue was surprising to us. We had expected the uncertainty and downside risks from the omicron COVID variant to delay such a decision.
In the grand scheme of things, an accelerated taper that concludes asset purchases in March instead of June is not a big deal if the economy continues to recover rapidly. After all, asset purchases have their most material impact on the economy and markets during a crisis, and we are now 20 months removed from the darkest days of the lockdowns. We just hope the Fed doesn’t pre-commit too much here in accelerating the removal of accommodation. Commodity prices are rolling over, supply chains are starting to heal (ever so slightly), and COVID risks are amplifying. Uncertainty argues for patience. Call it strike one toward a Fed policy mistake. Now, there’s a sentence I haven’t written in a while.
What risks could the omicron variant pose to markets?
Finally, a bit more on omicron. There’s very little that we actually know at this point. It’s likely to be very transmissible, given the rapidity with which it has become the dominant strain in South Africa and spread globally. And it’s also likely to significantly degrade the protection provided by current vaccines—after all, the leading COVID vaccines all target the spike protein, and the omicron variant has far more mutations on the spike protein than the delta variant, including some mutations that have already been shown in labs to reduce vaccine efficacy.
Obviously, there are a constellation of mutations that can offset one another in unexpected ways, but there are some clear yellow flags here to be aware of until the science is completed. We also don’t know how severe omicron is. Some early anecdotes suggest it might be milder. On the other hand, hospitalizations in South Africa’s Guateng province are picking up.
Here’s a bit of good news to digest: the U.S. economy is very dynamic, companies have learned hard lessons about how to adapt, operate and in many cases profit in a pandemic, and the leading messenger RNA vaccine manufacturers can quickly reformulate their products to the new variant, if necessary. Bottom line: we don’t expect another economic collapse, à la spring 2020.
From a macroeconomic perspective, we are still constructive on the year ahead. The consumer is on strong footing. Businesses are flush with cash and capital intentions are strong. But this is clearly an important downside risk that we’ll all be learning more about in coming weeks. For now, we are tweaking macroeconomic scenarios and probabilities (from squarely bullish to a bit more balanced). Above all else, we believe that omicron is one of those risk factors that makes it prudent for clients to stick to their long-term strategic plans. Simply put, trying to out-forecast epidemiologists (who don’t have a great track record forecasting the pandemic anyway) is hard—bordering on foolish, if not impossible.
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