FOMC preview: Elevated inflation looks set to bring Fed tapering phase

The Federal Open Market Committee (FOMC) returns to the fold this week, with investors widely expecting to see the committee initiate tapering on a whopping $120 billion per month asset purchase programme. The two-day meeting concludes on Wednesday 3 November 2021.

Inflation and growth provide basis for tightening phase

The Federal Reserve bank (Fed) are expected to begin easing off the gas as rising inflation puts pressure on the committee to take some heat out the economy. The Covid-19 pandemic has brought plenty of volatility for markets, but it has been noticeable that some of the most significant price movements have come from the commodity sector. Rising input prices come at a time when businesses attempt to regain lost earnings by upping the prices in the wake of their reopening.

The supply-chain issues seen around the world have raised questions over the ability to satisfy healthy levels of demand, with that lack of supply only serving to highlight the risk of further prices gains in the months ahead. The chart below highlights how the pressure on physical products has sparked a particular rise in goods over services. That jump in goods has brought headline consumer price index (CPI) to the highest level since the financial crisis, although there are few signs that the prices are about to normalise as swiftly as they did in 2008.

While elevated inflation does bring the potential for hawkish shift from the Fed, they are less likely to do so if the economic picture remains at risk. While we have seen growth ease back somewhat in third quarter (Q3), it feels as though the economy is back on a more stable footing.

On the jobs front, the picture similarly points towards continued improvements as businesses ramp up hiring ahead of a busy festive period. The problems within the jobs market appear to be related more to a difficulty finding employees rather than an unwillingness to hire.

The fact that US job vacancies have spiked to a record high does illustrate that lack of concern around the jobs market. Below we can see that the number of unemployed persons per job opening stands at pre-crisis levels despite unemployment being significantly higher (4.8% vs 3.5%).

All in all, we can see the persistently high inflation, coupled with healthy growth and employment provides the basis for the Fed to begin easing their expansive monetary policy stance. The wider context of how much the Fed have acted to help avert an economic crisis can be seen below, with traders wise to compare the growth in the Fed balance sheet over the past two years to that within the six years from 2008. There is no doubt that the Fed has delivered in size, and it is time to start reigning in that massive asset purchase programme.

What to expect from the Fed

Markets are relatively confident that the Fed will act this week, with traders largely expecting to see the Fed implement a $15 billion monthly reduction to the current $120 billion per month policy. That $15 billion reduction is expected to comprise of split $10 billion from treasuries and $5 billion of agency mortgage-backed securities (MBS). As such, we could see the asset purchase programme draw to a close by June 2022. However, it is likely that we could see that rate amended as we go forward, depending on the direction whether inflation, growth and jobs take.

What about interest rates?

With the asset purchase programme widely expected to draw to a close by the end of Q2 2022, we are likely to swiftly shift our focus towards interest rates. Unlike a move to trim monthly asset purchases, a rise in interest rates would actually serve to tighten financial conditions in the country. A look at the latest dot plot highlights expectations that we could see rates really pick up in 2023. However, there are many that expect to see rates rise next year, with the dot plot highlighting that a majority see at least one hike by the end of 2022.

Looking at market pricing, we can see that traders take on a more hawkish stance. Instead, markets place a 46% chance that we will see three rate hikes by the end of next year. Meanwhile, they see a 77% chance of two hikes in 2022. Given that disparity, it provides the basis for market volatility as the Fed either shifts away from or towards that more hawkish stance.

Dollar index technical analysis

The dollar has enjoyed a strong five months, with the price gaining ground after falling back into the $87.93 to $89.71 support zone. However, we are clearly struggling to maintain that trajectory after reaching the March 2020 low of $94.54. The ability to break up through that level will be key in determining whether we continue this recovery or not.

The daily chart highlights how the dollar spiked on Friday, coming off the back of a decline into the 50% retracement level. A break below the $91.77 to $91.93 support zone would be required to bring an end to the recent uptrend. Until then, near-term downside looks a potential buying opportunity as the Fed begins to tighten monetary policy.