The US central bank is winding down QE faster than planned – so why are markets bouncing?
The Federal Reserve is to speed up the pace at which it is winding down QE, its money-printing programme. But instead of going into shock, stockmarkets rose. John Stepek explains what's going on.
Last night, the Federal Reserve, America’s central bank, announced the results of its last interest-rate setting meeting of 2021.
Markets had been waiting with bated breath. The US central bank was expected to speed up “tapering” (ie, winding down its money printing). As it turned out, the Fed was even more “hawkish” than forecasts had suggested.
Did markets fall off a cliff in shock as a result? No, quite the opposite in fact.
The Fed was more hawkish than expected
The Federal Reserve has decided to double the pace at which it is tapering away quantitative easing (QE). As a result, the current phase of QE will end in February. Members of the Fed’s version of the Monetary Policy Committee also expect to raise interest rates three times next year.
This is all quite a long way from the views and opinions held just a few months ago, when as many as half of those expressing a view thought that there would be no rate rises at all next year (this is the infamous “dot plot” diagrams that now accompany each meeting, showing where Fed decision makers expect interest rates to be over the coming few years).
In short, this was not a central bank which is merely content to “let inflation rip”. So the obvious question is: why did share prices shoot up after the Fed was done? And why did even gold – widely, if not entirely correctly, deemed an inflation hedge – go up?
A few things might be going on here. One is that this is just a classic of the “sell the rumour, buy the news” variety. In the run-up to the meeting, investors have been like cinemagoers at a horror film.
Just as in a horror film, the tension mounts and mounts. By the time of the big reveal, the viewers’ imaginations are running wild with what awfulness might be unveiled. But when the mask does come off, it doesn’t matter how ugly the monster is – it’ll never be quite as ugly as the audience thought it could’ve been.
Similarly, Fed boss Jerome Powell has been warming investors up for this for ages. That meant they were positioned for potential disaster by the time the actual meeting came around. Instead, they got something that sounded aggressive, but which they realised could have been worse.
So that’s one reason why markets may have rebounded: investors were hedging against a proper crash; they didn’t get it and they closed the hedges.
Another is that markets might like the idea that the Fed appears to be taking inflation seriously. At the end of the day, investors realise that there’s a point at which inflation becomes very disruptive to markets. Maybe they are betting that the Fed can prevent the worst of the inflation without necessarily tipping the whole debt pile over in the process.
The Fed still doesn’t think inflation is here to stay
However – and this is related to that last point – most of the cheery reaction might also just be because it’s clear that the Fed still thinks that inflation is “transitory”, even if it is taking it a bit more seriously.
The Fed got rid of the word “transitory”, but only because it got annoyed with people taking that to mean a fixed period of time – and a short one at that.
Instead, the Fed got its thesaurus out and found a collection of phrases and sentences that mean the same thing as what it likes to pretend it meant all along. In other words, the Fed still thinks that inflation is an issue caused by supply chain woes that will eventually be ironed out as re-opening continues.
This is backed up by the dot plot. The number of interest-rate rises might have been pulled forward, but in the longer run, there’s no indication that inflation is here to stick around. In fact, as John Authers of Bloomberg points out, “the Fed’s governors still believe that rates will never need to go higher than 2.5% where Fed funds peaked in 2019".
In other words, the Fed is still predicting a low-rate, low-inflation environment, even if it feels the need to wave a big stick around right now. Business as usual, if with a slightly growlier tone.
Powell also reassured markets that he’s aware of their fragility, and that he’s willing to change course as needs be. “If the economy were to slow, then that would slow rate increases”.
As a result of all this, investors got their “buy the dip” hats back on and pushed the Nasdaq 100 index back up from its recent slip. Of all the major global indices, the Nasdaq is one of the most tech-heavy and therefore arguably interest-rate sensitive.
Will this continue? Barring any big surprises, the biggest central bank meeting of this year is now done and Powell has reassured traders that he’s not going to pull a Paul Volcker on them. It seems likely to me that the “Santa rally” that everyone has come to expect can now kick off without fear.
But as a long-term investor, you’re not worried about what happens over the next few weeks. Instead, I think you should take this to mean that for all the talk, the Fed is not particularly concerned about inflation and remains very wary of tightening monetary policy too aggressively.
The real goal is to manage inflation of around 3%-4% a year for a good few years, without upsetting the financial apple cart. That’s going to be a real challenge, and one that I suspect will be very hard to pull off. So make sure your portfolio has some inflation insurance, and that you also have the optionality to buy as and when the inevitable bouts of panic strike.