In the final months of this year, we expect the U.S. Federal Reserve to begin scaling back some of the extraordinary stimulus measures launched last year in the early stages of the pandemic. Although the Fed chose not to break any news about its first move at the September 2021 meeting, we already know the initial step. The central bank will begin by reducing, or tapering, the pace of its bond buying.
The last time the Fed tapered, it prompted the infamous Taper Tantrum of 2013. Markets were caught off guard and bond yields soared. With investors better prepared for tightening this time around, we don’t expect another tantrum. The Fed’s unwind has been well telegraphed with only the precise timing unknown. Let’s unpack that path and consider how it might affect fixed income markets.
Fed tapering soon but no hikes before late 2022
As recently as August, some investors believed that the Fed could announce the start of its taper program at its September meeting. The relatively weak jobs report paired with a softer inflation rate reading in August closed the door on that possibility, however. We now believe the Fed will announce its intention to taper as soon as its November meeting, unless economic conditions deteriorate significantly before then.
The U.S. central bank will probably begin tapering assets in the weeks following that announcement. Once that begins, based on the Fed’s previous statements and its prior tapering program, we expect it to last roughly six to nine months, most likely ending sometime around the middle of 2022. Currently the Fed is buying $120 billion of U.S. Treasuries and mortgage bonds each month. That amount will decrease gradually until the Fed is no longer adding any securities to increase the size of its balance sheet.
Once the taper has ended, the Fed will only buy assets sufficient to maintain the size of its balance sheet, replacing old securities that mature. At that time, the central bank will consider a three-part test prior to raising interest rates:
1. Has the economy achieved maximum employment?
2. Has core inflation — the rate that excludes food and energy prices — reached its 2% target?
3. Is core inflation on track to exceed its 2% target?
We’ll dig into these conditions next. We believe the Fed isn’t likely to begin considering hiking rates until late 2022 at the earliest. Once it does allow short-term interest rates to drift higher, we expect it to do so in a very gradual manner, as it did from 2015 through 2018.