Fed Announcement — November 3, 2021

No Change

Some things change and some do not. No surprise, the Fed left short-term rates unchanged and announced that it will reduce the amount of bonds it buys each month. A small surprise was the emphasis on “transitory” inflation. The Committee did acknowledge that “indicators of economic activity and employment have continued to strengthen.”

The Fed has no plans to raise short-term rates any time soon. The test for the Fed to raise short-term rates is a return to maximum employment and inflation averaging “2% over the longer run.” In contrast, futures markets are watching economic growth and inflation and believe the Fed will raise rates by one-quarter of a point at least two times next year.

Changing the inflation language was in response to criticism over the word “transitory.” Most traders, when asked what transitory inflation meant, thought that the Fed meant inflation would be with us for a few months and then recede. In other words, your grocery bill would rise then fall back close to where it was pre-pandemic. 

The Fed is now trying to qualify that wording. Today’s statement: “Inflation is elevated, largely reflecting factors that are expected to be transitory. Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increase in some sectors” Powell in his press conference admitted that inflation will be persistent. The above statement can be read as “transitory supply factors pushed prices higher, and prices are going to stay high just not rising as fast.”  

Tapering

The pace of the Fed’s pandemic quantitative easing program will be reduced over the next two months. The current program spends $120 billion per month buying U.S. Treasury and mortgage securities. In November and December purchases will be reduced $15 billion ($10 billion less in Treasuries and $5 billion less of mortgages) per month. The Committee will reassess the impact and economic data at its December meeting. Regardless of the reduction in buying, the Fed will maintain the existing portfolio of bonds, which supports a very accommodative monetary stance. 

Comment

The Fed’s test for reducing its bond purchases was continuing improvement in the economy. That test has been met by solid retail sales and gains in employment. The Fed now has two more tests before increasing short-term interest rates. These tests are “maximum employment” and average 2% inflation. The “average 2% inflation” test will be met sooner rather than later given consumer prices are averaging 4%- plus gains over the last year. Maximum employment could be the pre-pandemic low of 3.5%. 

Regardless as mentioned above, traders believe a recovering economy and continued job growth will force the Fed to raise rates at least twice next year. 

Inflation does appear to be moderating from recent highs. We expect CPI to stay above 4% for the next several months. Traders now have a more definite picture of how much the Fed will pull back from bond markets. Interest rates will continue to drift higher as the Fed’s buying support is reduced. 

The Fed meets again December 14-15. At that meeting the Fed will have two more employment reports and another Congressional debt ceiling to consider. This Friday’s October jobs report is expected to show a gain of 450,000 and unemployment rate of 4.7%. The ADP private payrolls report this morning surprised observers with a gain of 571,000 new jobs last month, well above expectations. We believe continued improvement in the economy and persistent inflation will force the Fed to modify its criteria for raising rates next year. 

Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary's University School of Law. Follow him on Twitter here. Greg Kalb is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts from The University of Texas at Austin.

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