Fed dials back bond purchases, plots end to stimulus by June

The Federal Reserve will reduce its bond purchases by $US15bn a month in November and by a further $US15bn in December, and end it by June.

The Federal Reserve, chaired by Jerome Powell, has approved plans to begin scaling back its bond-buying stimulus program this month and end it by June. Picture: Kevin Dietsch/Getty Images/AFP

The Federal Reserve approved plans to begin scaling back its bond-buying stimulus program this month and end it by June, a major step toward withdrawing its aggressive, pandemic-driven economic support amid a recent inflation surge.

Fed officials in their postmeeting statement Wednesday said they still anticipated elevated inflation would fall because high readings are “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 sizeable price increases in some sectors,” the statement said.

The Fed cut its short-term benchmark rate to near zero when the coronavirus pandemic hit the US economy in March 2020. It held rates at that level on Wednesday.

It also has been buying at least $US120bn ($A161.05bn) a month in Treasury and mortgage securities — initially to stabilise financial markets and later to hold down longer-term interest rates. The Fed’s holdings of those securities has more than doubled since March 2020 to around $US8 trillion.

The Fed will reduce its bond purchases by $US15bn a month in November and by a further $US15bn in December, the central bank said Wednesday. It said similar reductions in the pace of net purchases “will likely be appropriate each month,” though officials would be prepared to adjust that pace “if warranted by changes in the economic outlook.” Fed Chairman Jerome Powell has so strongly signalled in advance the decision on the asset purchases that investors focused more on how he characterised inflation risks at his news conference — and the implications for how soon the central bank might raise interest rates.

He put greater emphasis on the uncertainty facing the outlook for inflation. “We continue to believe that our dynamic economy will adjust to the supply and demand imbalances,” he said. “It is very difficult to predict the persistence of supply constraints or their effects on inflation.” Supply chains “will return to normal function but the timing of that is highly uncertain.” He also said, “We remain attentive to risks and will ensure that our policy is well positioned to address the full range of plausible economic outcomes.” Fed officials don’t want to lift rates until after they have ended the bond purchases. Mr Powell has slightly moved up plans to wind down those purchases, relative to earlier market expectations, as inflation has soared this year.

Brisk demand for goods, disrupted supply chains, temporary shortages and a rebound in travel have pushed 12-month inflation to its highest readings in decades. Core inflation, which excludes volatile food and energy prices, rose 3.6 per cent in September from a year earlier, according to the Fed’s preferred gauge.

From April through September, the Fed’s statement described high inflation as “largely reflecting transitory factors.” Wednesday’s statement included additional language to characterise why officials still expect prices to decline. “Progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation,” it said.

Since officials’ previous meeting in September, inflation data have hinted at a potential broadening in price pressures and at the prospect that prices for certain items such as used cars, which witnessed sharp gains earlier this year, have started climbing once more.

While the data don’t necessarily disprove the Fed’s earlier expectations that certain price increases tied to the reopening of the economy this year from the pandemic will fade over time, it does at least augur a longer interval of elevated inflation readings.

“Supply-side constraints have gotten worse. The risks are clearly now to longer and more-persistent bottlenecks, and thus to higher inflation,” Mr Powell said last month.

Higher inflation readings and policy pivots by other similarly-situated central banks have led bond investors to anticipate that the Fed will raise rates next summer, after it stops buying bonds, and again later in the year.

Mr Powell has been seeking a middle ground that assures investors the Fed is closely monitoring inflation risks while not appearing so worried that he leads markets to anticipate an even faster pivot to tighter money. The expectation that inflation-adjusted interest rates will remain low have buoyed global asset prices. The Fed risks triggering new economic or financial stress by shifting abruptly.

The Fed last year set a test for raising interest rates that would require inflation to be on course to moderately exceed 2 per cent while the labour market broadly returns at least to levels consistent with employment conditions that prevailed before the pandemic.

The Fed is paying very close attention to signs that consumers and businesses expect higher prices to continue rising — or what is referred to as the “un-anchoring” of inflation expectations.

The Fed places tremendous importance on inflation expectations because it believes they can become self-fulfilling. Officials have based their forecasts that high inflation would abate on its own because it has been closely related to the pandemic, which they likewise expect to have a beginning, middle, and end.

Some Fed officials have said they are nervous that a longer interval of higher prices could threaten a 25-year trend of inflation that has held around their 2 per cent goal. A related risk is that the recent pattern of supply-chain disruptions lingers into 2022 and beyond, preventing a return to the pre-pandemic equilibrium for the economy or labour markets.

Economists at Goldman Sachs last week changed their rate-path forecast to show the Fed raising rates from near zero next July, roughly a year earlier than their previous forecast. They expect the Fed will raise rates sooner because the current period of higher inflation will persist into the middle of next year, even though they still expect inflation to fall to 2 per cent by early 2023.

The Wall Street Journal