Important FOMC meeting coming up: How markets might react

A plethora of G10 and Emerging Market central banks are deciding on policy next week, but by far the most important amongst them if the US Federal Reserve (often referred to as the Fed). The Federal Open Market Committee (FOMC), a twelve-member committee that decide on the Fed’s monetary policy, has a two-day meeting scheduled next week, the conclusions of which will be announced at 1900BST on Wednesday the 22nd of September. The bank is widely expected to leave both its federal funds target range (current at 0.0-0.25%) and the pace at which it is currently conducting asset purchases (currently at $80B per month in treasuries and $40B per month in mortgage-backed securities) unchanged. But the bank will release a new statement on monetary policy, which will offer an update as to how the FOMC views current economic and financial conditions, as well as potentially offering some further guidance to markets about how Fed policy is set to evolve over time. The Fed is also scheduled to release updated forecasts for growth, unemployment and inflation over the next few years, as well as an updated dot-plot – this is a chart that, on the x-axis, shows the timeline of Fed meetings over its economic forecast horizon and, on the y-axis, shows the interest rate. At each interval on the x-axis representing each Fed meeting over the bank’s forecast horizon, each FOMC member places a dot to represent where they think interest rates will be at the time of that meeting. Thus, the dot-plot is seen as a useful tool to give markets some forward guidance by representing how FOMC members see interest rates changing over the coming years.

The main market focus with regards to FOMC policy right now is when the bank is going begin to reduce the pace of asset purchases, signalling an official end to the pandemic era emergency stimulus that helped, at the time, fend off a financial crisis that would have ultimately worsened the 2020 recession and prolonged the post-pandemic recovery. The official guidance from the Fed at the moment is that only wants to begin winding down its QE programme when “substantial further progress” has been made back towards its goal of full employment. This is, of course, intentionally vague so that the Fed can maintain optionality regarding when it starts unwinding stimulus, meaning they can be nimbler in their response to any changes in economic conditions. The guidance from the Fed regarding when it will begin tapering its QE programme makes no reference to inflation (price stability being the other part of the Fed’s dual mandate). That’s because inflation has already shot way above the Fed’s 2.0% target – CPI has been above 5.0% YoY for months and Core PCE (the Fed’s favoured gauge) is likely to exceed 4.0% YoY this August. In other words, the Fed thinks it has already achieved its 2.0% inflation target.

Indeed, though the official FOMC line is that the spike in inflation metrics over summer is going to be transitory (i.e. driven by temporary phenomena such as base effects, post-pandemic reopening, fiscal stimulus and supply chain disruptions), fear on the committee appears to be growing that inflation may remain at persistently high levels (i.e. above 3.0%) for a prolonged period of time. Thus, some on the FOMC have been vocal about the need to quickly begin tapering the bank’s QE programme in order to “create space” for rate hikes in 2022, if needed (i.e. if inflation turns out not to be transitory). The official line from core FOMC members such as Chairman Powell on when the bank might begin its QE tapering has been left deliberately vague, with core officials saying it may be appropriate to begin winding down bond-buying before the end of the year.

A recently conducted poll by Reuters showed that more than 60% of economists expect the FOMC to commence its QE taper in December and 70% expect the bank to conclude its taper (i.e. net monthly purchases brought down to zero) some time before Q3 2022. Next week’s FOMC meeting will help to shape such expectations; the FOMC statement may offer hints as to the bank’s QE tapering timeline and Fed Chair Jerome Powell might also offer hints in his post-FOMC meeting press conference. In terms of how markets might react as the Fed shapes such expectations; any indications of an earlier than December start to QE tapering and/or an earlier than Q3 end to the tapering process would be read as a hawkish signal, likely supporting the US dollar, US bond yields and perhaps hurting stocks and precious metals. This would more be a reflection of the fact that a more aggressive QE taper would cause markets to start betting on earlier rate hikes (as it may signal that the Fed is “in a rush” to reel in its extra-ordinary monetary accommodation measures) than it would be a reflection of the fact that a faster QE taper constitutes a large change in economic or financial conditions for the US economy (it doesn’t).

However, many analysts suspect that the Fed may continue to kick the can down the road regarding further guidance on the QE taper given 1) rising economic risks as a result of rising Covid-19 infection rate in recent months, which will likely be reflected in the FOMC’s GDP growth forecasts which may be downgraded slightly for 2021, 2) a weaker than expected August payroll number that showed the economy adding only about 250K jobs on the month, well below the roughly 1M jobs added over the course of each of the prior two-months and, finally, 3) given the Fed’s current guidance which says it may start tapering its QE buying by the end of the year, what’s the rush to give away information in September? The bank has a further two meetings (in October and December) to make such an announcement, so if it wants, it could continue to bide its time, which would be used to observe further economic data (most important of which would be the September jobs report, scheduled for release in early October). If the Fed did choose not to offer any meaningfully new information regarding its QE taper at next week’s meeting, this would likely be within the market’s expectations, though there may be some “relief” in the form of modest USD, US bond yield weakness and strength in precious metals and stocks.

But even if the FOMC does kick the can down the road regarding the QE taper, we will be getting a hefty dose of new information that could inform longer-term interest rate expectations in the form of the updated economic projections and the new dot-plot. Over the course of the last month, markets pricing for Fed hikes in 2022 has become more dovish; where one month ago money markets were pricing nearly a 70% chance that there would be at least one 25bps hike from the Fed by the end of 2022, that probability has now dropped to just under 55%. Meanwhile, the chance of at least one 25bps rate hike by the September 2022 meeting has dropped from over 40% one month ago to close to 25%. That is quite a dovish shift that seems to reflect some of the above-noted risks (Covid-19 and the weak August payroll number). A further shift in these expectations is possible if, for example, big changes are made to the Fed’s inflation forecasts (which could well be lifted) or employment forecasts (unclear if there will be any change) or to the dot-plot (which may well see further FOMC members predicting rate hikes in 2022 given inflation concerns). A big change in the dot-plot in June (which unexpectedly saw a host of FOMC members suddenly predicting rate hikes in 2022 and a majority in 2023) was part of the reason why there was a huge surge in the US dollar (and a large intra-day crash in gold) in the aftermath of the meeting.