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Federal Reserve Chairman Jerome Powell.

Graeme Jennings-Pool/Getty Images

There was a time when Federal Reserve officials made their policy intentions as clear as mud. No more.

Jerome Powell, the current central bank chief, said Wednesday that the announcement of the beginning of the tapering of its $120 billion monthly purchases of Treasury and agency mortgage securities “may soon be warranted.” 

The Fed’s bond buying then could wind down by around mid-2022. That would set the stage for the liftoff of the key federal-funds target rate by late next year, which now is anticipated by nine of the 18 members of the Federal Open Market Committee, up from seven when the previous “dot plot” of forecasts was issued in mid-June.

That’s not too different from what many Fed watchers have been expecting. If anything, Powell has been pulled along by some hawks who have been calling for an immediate start to tapering of Fed purchases, says Vincent Reinhart, chief economist for Mellon and its Dreyfus unit and former economist at the FOMC. 

Powell’s plan takes into account what he sees as the “asymmetric” nature of policy risks for the Fed, Reinhart points out in an interview.

At the Fed chairman’s Wednesday press conference following the FOMC meeting, he opined that the condition of achieving progress of inflation exceeding its 2% target had been met. Indeed, the FOMC’s new Summary of Economic Projections showed the personal-consumption expenditures deflator, the Fed’s preferred inflation gauge, clocking in at 4.2% in 2021, up from 3.4% in the June SEP. Consistent with the Fed’s official stance that the surge in prices is “transitory,” its new SEP anticipates the PCE deflator to rise 2.2% in the next two years.

The unemployment rate is seen coming down to 4.8% by year-end, from 5.2% in August—a smaller decline than the drop to 4.5% envisioned in the June SEP. As the FOMC policy statement noted, the rise in Covid-19 cases as slowed the recovery in sectors most affected by the pandemic. From there, the panel sees the jobless rate receding further, to 3.8% at the end of 2022 and 3.5% at he end of 2023.

The asymmetric risk is that the labor market fails to improve as the Fed anticipates, Reinhart explains. So Powell is likely to err on the side of an easier policy. 

If the recovery is stronger and inflation runs hotter, it wouldn’t be a problem for the Fed to pick up the pace of normalization of policy. That would consist of, first, accelerating the slowing of its securities purchases, and then pulling forward its eventual increase in the current rock-bottom fed-funds target range of 0%-0.25%. 

By contrast, employment is the primary Fed policy variable, and the Fed has yet to make sufficient further progress to its goal of maximum full employment (which remains ambiguous, maintaining that tradition of central bankers). If the recovery falls short of expectations, it would be far more difficult to reverse course on policy normalization, Reinhart points out.

In response to a question at his post-FOMC press conference, Powell said the Fed would have to wind up its securities purchases before it could start raising its fed-funds target. Buying bonds adds reserves to the banking system, which tamps down short-term interest rates, so those purchases would be at cross-purposes with trying to hike rates. 

Following Powell’s presser, the fed-funds and Eurodollar interest rate futures have virtually priced in a quarter-point Fed hike by the end of 2022, which is relatively more certain than the nine-to-nine split shown in the “dot plot” in the Fed’s SEP. 

In the Treasury market, the yield curve flattened, with the two-year note yield moving up two basis points to 0.24%, while the 10-year benchmark yield dropped two basis points, to 1.30%. (A basis point is 1/100 of a percentage point.) A flatter yield curve typically reflects the market’s expectation of a less accommodative monetary policy. 

But not so stringent, apparently, as to deter stock bulls. All three major averages posted strong gains of about 1% Wednesday, shaking off Monday’s drop and making for the strongest percentage rise for the

S&P 500
since July 23, according to our colleagues at Dow Jones Indexes.

So Powell made clear the normalization of Fed policy will begin later this year, which financial markets evidently have been prepped for already.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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