Federal Reserve concludes tapering as it recalibrates monetary policy to fight inflation

May 6, 2022 | Market news

The Federal Reserve (Fed) continues to pursue a new monetary policy direction. Its revised stance is primarily a response to the notable resurgence of inflation. Fed Chairman Jerome Powell has stated that “Inflation is much too high and we understand the hardship it is causing. We’re moving expeditiously to bring it back down.”1 The sudden surge in the cost-of-living has emerged as the dominant concern for consumers, investors, government policymakers and the central bank this year.

Powell has made clear that the Fed will take necessary steps to tamp down the inflation threat. The policy making Federal Open Market Committee (FOMC) started that process at its March meeting by raising interest rates and ending its asset-purchase program that provided liquidity to the bond markets. At its May meeting, the Fed again raised interest rates and announced that it would begin reducing the asset holdings its accumulated in recent years. According to Powell, these steps are the beginning of the Fed’s money-tightening measures.

What specific actions can investors expect from the Fed going forward and how should investors prepare for the impact of these changes on their own investments?

Background on the Fed’s role

The Federal Reserve acts as the U.S. central bank. While its functions include maintaining an effective payment system and overseeing bank operations, markets are most interested in the Fed’s monetary policies.

In setting monetary policy, the Fed attempts to fulfill three mandates:

  • Price stability. The Fed seeks to maintain a stable inflation rate. Its current target is inflation averaging 2% per year.
  • Maximum sustainable employment. Officially referred to as “maximum employment,” it technically refers to a labor market where the unemployment rate is at a low level. Rather than a specific measure (i.e., unemployment rate, labor force participation rate) to determine whether the goal has been attained, it involves a more subjective assessment of the employment environment by the Fed.
  • Maintain moderate long-term interest rates. Because the level of interest rates can impact economic activity from consumer mortgages to business financing, the Fed seeks to keep rates at modest levels.

The Fed also influences short-term interest rates, specifically, the so-called federal funds (or fed funds) rate, which is the interest rate applied to overnight loans from one financial institution to another. While Chairman Powell receives much of the attention, the FOMC establishes Fed monetary policy. It’s the committee that sets the fed funds rate target and has other authority, including buying and selling of securities.

An end to the era of “quantitative easing”

Along with adjusting short-term interest rates, another strategy the Fed has implemented in more challenging economic periods is known as quantitative easing (QE). In these instances, the Fed uses its purchasing power to buy longer-term securities on the open market. By investing in securities (typically in the fixed income market), the Fed adds liquidity to encourage economic activity through more lending and investment. This strategy is particularly useful when adjustments to the fed funds rate are no longer possible if the rate is already at an extremely low level.

As the COVID-19 pandemic emerged in March 2020, the Fed implemented an aggressive QE strategy. It immediately injected more than $700 billion in asset purchases at that time. In June 2020, it implemented QE again to purchase $120 billion of bonds per month – $80 billion in U.S. Treasury securities and $40 billion in mortgage-backed securities. That program continued until the Fed started tapering its purchases in December 2021.

“Under this program, the Fed became one of the biggest buyers of Treasury securities in the market,” says Tom Hainlin, national investment strategist at U.S. Bank. “They had an impact on the interest rate environment just by their large presence.” Hainlin notes that with the Fed bumping up demand for bonds, long-term interest rates remained low (high demand for bonds typically helps keep interest rates lower).

The QE program coincided with the Fed’s move to reduce the short-term fed funds rate dramatically in the early weeks of the pandemic. It lowered the fed funds target rate from 1.75% in February 2020 to 0.25% about one month later. It has remained at that level, what observers refer to as a “zero interest-rate policy” or ZIRP, since that time.

Inflation alters the economic landscape

The economy quickly bounced back after the severe recession in the first half of 2020. As measured by Gross Domestic Product, the U.S. economy grew at an annualized rate of 5.7% in 2021, the fastest rate of growth in a calendar year since 1984.2 At the same time, inflation continued to accelerate. For all of 2021, the Consumer Price Index grew by 7%, the largest calendar-year change in the cost of living since 1981. At the end of March 2022, the 12-month inflation rate jumped to 8.5%. These readings are much higher than recent average annual changes in the CPI.3 The resurgence and persistence of inflation caused the Fed to reconsider its monetary policy.

A major shift in direction was implemented in March 2022, as the Fed brought an end to its monthly bond purchases. That eliminated what had been an injection of $120 billion monthly into the bond market. After its May meeting, the FOMC appeared to form a consensus around a plan to start reducing positions in Treasury securities, agency debt and agency mortgage-backed securities by $47.5 billion per month initially, stepping up to $95 billion monthly by September.4 At the end of April, the Fed’s balance sheet included assets that totaled nearly $9 trillion.5 “This means investors will have to do more of the heavy lifting in the bond market,” says Bill Merz, head of capital market research at U.S. Bank. “If inflation remains an issue in combination with the Fed pulling back on its bond holdings, it’s likely to result in somewhat higher bond yields.”

While the Fed’s choices to buy bonds or reduce its bond holdings are most likely to affect interest rates on the long end of the yield curve, setting the target fed funds rate directly impacts the short end. At its March 2022 meeting, the FOMC voted to raise interest rates 0.25%, the first time it boosted the fed funds rate since 2018.1 At the FOMC’s May meeting, interest rates were raised by 0.50% – the largest single rate hike by the Fed since 2000. This brought the fed funds target rate to the 0.75% to 1.00% range.6 Projections released by the Fed indicate rate hikes totaling 1.75% or more are anticipated in 2022.7

Across the bond market, Fed rate hikes will likely push yields on short-term securities higher while its reduction of its balance sheet (asset holdings) could result in higher long-term rates. These purposeful strategies have a goal of cooling the rapid rate of growth in living costs. “The Fed is trying to find the delicate balance between stemming the inflation threat without having a significantly negative impact on economic growth,” says Merz.

Russia’s invasion of Ukraine and the economic fallout from it may be a complicating factor for the Fed. Among other concerns, Russia is one of the world’s major producers of oil and natural gas, and both Russia and Ukraine are major agricultural producers. To the extent supplies of commodities are disrupted as a result of the military conflict, it could exacerbate inflation’s impact in the short term.

Inflation data going forward will also be a factor in the Fed’s approach to rate hikes. The inflation surge in 2021 was attributed at least in part to factors like supply chain issues. Strong demand for goods at a time when spending on “services,” (events, travel, etc,) were curtailed also drove prices higher. A bigger question now is whether an accelerated pace of economic growth will keep inflation rates elevated. This highlights the challenge facing the Fed as it tries to bring inflation down without derailing the economic recovery. Minutes from the FOMC meeting in January 2022 indicate that the prevailing sentiment of its members is “that the appropriate path (of fed funds rate hikes) would depend on economic and financial developments and their implications for the outlook and the risks around the outlook.” The FOMC indicated it plans to update its assessments at each policy meeting.8

Merz points out that the Fed wants to avoid a situation where short-term rates rise faster than long-term rates, risking an inverted yield curve. When this occurs, it’s often seen as a harbinger of negative economic developments. In early April 2022, the yield curve inversion between 2-year and 10-year Treasury securities occurred briefly. Some investors may pay closer attention to the relationship between 3-month and 10-year Treasury yields. As of May, both still follow a normal pattern, with a reasonable spread between the two maturities, but it will be a trend worth watching. “If long-term yields don’t move much despite the Fed’s tapering and unwinding of its balance sheet, it may put some constraints on how much the Fed can afford to raise short-term interest rates,” says Merz.

“The Fed is trying to find the delicate balance between stemming the inflation threat without having a significantly negative impact on economic growth.”

– Bill Merz, head of capital market research at U.S. Bank Wealth Management

Will the investment environment change?

In light of the Federal Reserve tapering strategy and the anticipated fed funds rate increases, investors should prepare for possible impacts.

  • Fixed income market. Much of the focus will be on changes in interest rates. The Fed ending its role as a buyer in the bond market will result in less demand for bonds, which has already put upward pressure on interest rates. “The bonds most susceptible to negative consequences from rising interest rates are the safest – Treasuries and investment-grade corporate bonds,” says Merz. Investors may want to maintain an underweight position in fixed income investments as the Fed works through its monetary tightening approach.
  • Residential real estate. As the Fed draws down some of its holdings in mortgage-backed bonds and eventually brings that process to an end, mortgage rates could go higher, a trend that has already occurred in 2022. Hainlin sees more room for maneuvering here. “While home prices have risen significantly, people are still buying houses, so that indicates the market is healthy.” Given that situation, Hainlin believes that a modest rise in mortgage rates as a result of the Fed’s change may not be a major deterrent to healthy activity in the housing market.
  • Equity markets. Recent events led to a modest downgrade of expectations for equities. “If the Fed continues to reverse multiple years of monetary policy by raising rates, but we have a lack of fiscal policy (federal government spending) as we head into a slowing economy, it could be problematic for risk assets,” says Freedman. He expects market volatility to continue given the war in Ukraine, ongoing inflation concerns and as a response to continued Fed monetary tightening.

“2022 will be unlike 2021, with the potential for volatility high and the range of outcomes wide,” says Merz.

Be sure to consult with your financial professional to review how your portfolio is currently positioned and if changes might be appropriate given expectations for what could be a rapidly changing investment landscape.

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