Wednesday 28 July 2021 2:29 pm

Weaker economic backdrop presents fresh headaches for Fed

Today’s Federal Open Market Committee announcements come amid mounting concerns that the rapid rise in Covid cases could dampen the global economic recovery.

This backdrop presents a different set of problems for Fed Chair Jerome Powell to when he last spoke in June. Recovery prospects are still good, but have tempered.

Investors around the world will be looking to see how the central bank is intending to respond to the weaker outlook. The FOMC will announce the outcome from its latest round of meetings today at 7pm UK time.

Wall Street wants certainty

Investors are realistic about the Fed pivoting from its current monetary policy stance anytime soon. Analysts at BlackRock expect the central bank to start normalising rates in 2023 – much earlier than first expected, but still far enough into the long grass.

Rates currently stand at a record low 0 per cent – 0.25 per cent.

Read more: Weekend Read: Job market tension threatens to derail Britain’s economic recovery

“It is extremely likely that the FOMC will not yet see the “substantial further progress” recently requested by Jerome Powell for starting the tapering,” thinks Carlo Alberto De Casa at Kinesis.

One of the main concerns on Wall Street is whether equity prices will hold once monetary policy does start to tighten. Typically, stocks benefit from accommodative policy as investors seek higher yielding assets by pouring cheap money into equity markets. Once the money taps are turned off, demand for stocks may fall sharply, putting downward pressure on valuations.

Uncertainty may already be creeping into US markets as investors predict how the Fed will react to economic data.

“Sharp price swings are the latest example of markets overreacting while grappling with the unusually wide range of potential outcomes that lie beyond the restart of economic activity,” analysts at BlackRock said in a briefing note.

Read more: Powell: US inflation likely to run hot in coming months

Fundamentally, traders want certainty from the Fed. Chair Powell will need to communicate the central bank’s position in a measured way to prevent volatile market movements.

Jobs market provides little comfort

“For all the optimism over economic reopening, the reality is that coming out of the pandemic is likely to be a much longer road than the market has been originally pricing,” warns Michael Hewson, chief market analyst at CMC Markets UK in London.

The rationale behind this sobering statement can be seen in the US labour market. Powell is unlikely to have been buoyed by data published last week showing US jobless claims reaching a two month high, possibly driven by firms reining in investment until they have greater certainty over their long term prospects.

Read more: Covid recovery: IMF predicts UK economy to grow fastest of all G7 nations

The Fed has prioritised achieving high employment before it even considers tightening policy.

Consumer confidence is at a 17 month-high, suggesting US households are ready to spend on goods and services that have been largely unavailable since the arrival of Covid.

However, one data point that Powell is likely keeping a close eye on is US house prices – latest figures show they rose at the fastest pace for 17 years in May. The last time that happened, it was driven by banks extending mortgages to buyers with poor credit scores, which partly triggered the financial crisis after a wave of defaults.

Inflation is still the big fear

The major concern on Wall Street is still spiralling inflation.

Price rises are being stoked by supply chains buckling under the weight of demand roaring back to life as economies emerge from Covid restrictions. Worker shortages are also feeding into predictions that inflation will remain higher in the long run if businesses have to increase wages.

Leading international economic organisations are starting to signal to the likes of the Fed and the Bank of England that they need to be ready to respond quickly should price rises get out of control.

Read more: US inflation surges at fastest pace in over a decade

The IMF said in its latest World Economic Outlook, published on Tuesday, that central banks need to be alive to the threat of inflation. The Fed will likely nod to the IMF’s warning today, which could prompt a sell off in bond markets and send yields higher.

QE under scrutiny

The Fed is likely to keep the scale and pace of its monthly $80bn Treasury and $40bn mortgage securities purchases unchanged – although it will provide some clues on its taper timeline.

QE has come under intensifying scrutiny recently, with experts suggesting it has contributed to widening wealth inequalities by inflating asset prices. House prices in the UK are 30 per cent higher than their 2008 peak, suggesting some of these accusations have merit.

The real headache for not just the Fed but central banks across developed economies is how to avoid a sharp rise in borrowing costs as they pull back from bond markets.

This rise could stem from two factors: if the Fed communicates tapering bond purchases poorly and sucking a large proportion of demand from the market.

The former is what caused the infamous taper tantrum nearly a decade ago. The latter is what could prompt it to resurface this time around.

“It is essential that the Fed, once it decides to announce its tapering operations, provides clear and concise forward guidance,” warns Joe Brusuelas, RSM chief economist.

Read more: Lords: Bank of England has become “addicted” to quantitative easing

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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