Preview of the Fed meeting: 3 things to watch as officials eye pandemic inflection point

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The Federal Reserve is teeing up a big policy change that could go as far as lifting mortgage rates or yields on certain savings products.

The question, however, is how to do it and when — particularly as Wall Street frets about a slowing economic backdrop and the contagious COVID-19 delta variant.

The Federal Open Market Committee (FOMC) will be picking up talks about a complicated bond-drawdown policy known as “taper” next week during its two-day meeting on July 27-28. The conversation has big implications for consumers and investors, with taper being the Fed’s first step toward withdrawing the extraordinarily accommodative measures it instituted in the wake of the pandemic.

On the one hand, the U.S. economy has rebounded much more sharply than officials had anticipated just in December, with policymakers upgrading their growth forecasts by nearly 3 percentage points over the past seven months. That gives the Fed more impetus to withdraw support sooner rather than later.

At the same time, concerns are forming about whether the rebound has already peaked following the steep pandemic-induced plunge in 2020. That might mean the economy needs all the stimulus it can get, especially as new coronavirus hot spots form in unvaccinated pockets of the U.S., and the closely watched delta strain makes up more than 80 percent of those new cases. Officials have long reiterated that the outlook remains uncertain — and that the Fed will need to remain vigilant — as long as the pathogen remains a threat.

“It puts a wrinkle into what we had thought was a steady path toward Fed tapering,” says Greg McBride, CFA, Bankrate chief financial analyst. “They’re still going to talk about tapering; it’s still going to be issue No. 1 in their discussions. But the potential headwind it may pose to economic growth is likely to make the Fed even more hesitant to take any steps toward removing accommodation.”

Here’s what you should be aware of ahead of the Fed’s July meeting, including what we know about how taper could work and how it could impact you.

1. The taper talk: Will the Fed provide more details?

The Fed has been buying a cumulative total of at least $120 billion a month worth of Treasury and mortgage-backed securities. Those moves helped bring down borrowing rates to their lowest levels ever, with mortgage rates sinking to historic lows and fueling a refinance boom — crucial stimulus at a time when the financial system was in peril.

The Fed has said they’ll be looking for “substantial further progress” before reducing how much they’re buying, a vague statement that’s leading to some divergence.

One camp of officials sees the economy returning to its pre-pandemic size by the end of this year. They also are watching inflation rise by the fastest pace in decades. Consumer prices excluding the volatile food and energy items soared by 4.5 percent, a 30-year high. Meanwhile, the Fed’s preferred tracker of inflation rose by 3.9 percent, the highest since 2008.

Officials do now want to see inflation average at 2 percent over time, though some regional Fed presidents are diverging with Powell’s view that those price increases will be temporary as reopening flukes, unprecedented pent-up demand and supply bottlenecks work their way through the financial system.

“We’re expecting a good year, a good reopening. But this is a bigger year than we were expecting, more inflation than we were expecting,” said St. Louis Fed President Jim Bullard in a June appearance on CNBC. “I think it’s natural that we’ve tilted a little bit more hawkish here to contain inflationary pressures.”

Policymakers closer to Powell, including New York Fed President John Williams, see that the economy still has a long way to go, with unemployment elevated and the economy still short of 6.7 million jobs.

“Execution is more difficult than the plan,” says Vincent Reinhart, chief economist and macro strategist at Mellon. “If you had a bad plan, you’ll have terrible execution, but a good plan doesn’t mean you’ll execute well. And vagueness and ambiguity gives you more discretion in the execution.”

Fed officials have repeated that they’d provide market participants with plenty of notice before beginning the official taper process. With officials diverging still on the path for policy, experts say it’s unlikely for the Fed to announce anything formal in the coming months, though that doesn’t mean they won’t ramp up talks about it at the July meeting.

The Fed’s upcoming annual economic symposium in Jackson Hole, Wyoming, could be a way for Powell to broadcast the Fed’s future policy plans surrounding tapering. Former chairs, including Ben Bernanke and Janet Yellen, have used the conference to lay the groundwork for such Fed thinking in the past.

2. On everyone’s mind: How will the taper process look?

But figuring out the right time to taper is only half the battle. Also front and center will be the formula for tapering, including what assets to sell off, how much and how quickly. The FOMC next week is bound to receive a briefing from staff on those potential taper scenarios.

Usually, tapering means that the Fed will first slow down its bond purchases until those hit zero; then, it will let assets gradually fall off its balance sheet, shrinking its holdings instead of growing them.

The Fed has had one go at it before. Following the financial crisis of 2008, the Fed in December 2013 began slowing its bond-buying, reducing those purchases by about $10 billion a month. The process ultimately culminated after 10 months. The Fed also reduced its mortgage-backed and Treasury securities purchases by $5 billion each back in 2013.

Experts, however, are questioning whether the process would look like that this time around, with some pointing out that the Fed might need to reduce its mortgage-backed securities purchases more quickly as affordability concerns pop up around the housing market.

Fed officials themselves have pointed out the validity for switching up the strategy this time around.

“I’m not sure that that’s necessarily the best approach this time because the economy is moving much faster here and the data is moving around and has a lot more variability than it did in that 2013-2014 period,” Bullard said in a July interview with the Wall Street Journal. “But, nevertheless, that was successful, and so we’ll see where the committee comes down on all these complicated questions.

Officials have indicated that they’d like to finish slowing down their bond purchases before they begin raising interest rates, which could happen by as soon as 2023. During the Fed’s June meeting, 13 out of the 18 Fed officials penciled in rate increases by 2023, while another seven expected rate hikes in 2022. That might provide more reason for the Fed to move faster on its drawdown than in previous periods.

McBride calls it a “pretty short runway to taper. If that is in fact the case, they’d be tapering at a pretty steep descent.”

3. Wall Street’s new concerns: Slowing growth and the Delta variant over inflation jitters

A month ago, investors and economists alike thought the Fed might walk a difficult tightrope when it comes to convincing market participants that the economy isn’t ready for taper, especially as inflationary concerns have popped up.

That’s changing now in the face of the rapidly spreading delta variant. The 10-year Treasury yield plunged to 1.27 percent in Thursday trading, after soaring to as high as 1.74 percent just four months ago. That’s sent mortgage rates tumbling to a five-month low, according to Bankrate’s latest survey of national lenders.

“The assumption is that the delta variant will not have any significant negative impact on the U.S. economy, but the Fed is being prudent,” says Kristina Hooper, chief global market strategist at Invesco. “The Fed is a different Fed than we’ve seen in the past. It’s far more responsive to current economic conditions.”

Suddenly, inflation concerns have taken a backseat as the pandemic proves that it isn’t over, though the delta variant could also exacerbate the issue. With emerging markets falling behind on vaccinations, the risk is that supply chain bottlenecks could worsen, Reinhart says, even if the U.S. shows better progress at containing the outbreak by administering more vaccines.

“It allows the economy to grow, but there are places we can’t go, places where goods and commodities can’t reliably come from,” Reinhart says. “We could be creating supply bottlenecks even as we solve the demand problem.”

All of that might give the Fed even more reason to be patient before formalizing any kind of taper timeline.

“More than anything it’s just justification for what they’ve been saying all along: The economy has a long way to go,” McBride says. “We’re not out of the woods yet with regard to the virus, and the unprecedented nature of reopening an economy after a pandemic has been reason to underscore why they’ve got their full speed ahead on accommodation.”

What this means for you

With mortgage rates sinking again, homeowners haven’t missed out on the opportunity to refinance, which could potentially shave hundreds of dollars off their monthly payment. Consider shopping around with at least three lenders to find the best rate and opportunity for your wallet.

Better yet, if you’re concerned about inflation eating away at your wallet, refinancing can be a strong way to free up cash that can safeguard your purchasing value in the face of higher costs.

“The drop in mortgage rates is stimulative to the extent that homeowners are able to refinance and reduce their monthly payments in a meaningful way, particularly with the cost of so many household items on the rise,” McBride says.

Investors will want to maintain a long-term horizon and ensure they’re diversified in the face of market volatility. The Dow dropped 2.1 percent on July 19, falling by about 725 points, in its worst day of the year. More of those days could be on the horizon, as the Fed announces a formal taper plan and the ongoing delta variant evolves.

“Maintain diversification, and don’t be surprised by volatility,” Hooper says. “It would be natural to have that as we prepare to hear from the Fed about the start of the policy normalization process.”

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Written by
Sarah Foster
U.S. economy reporter
Sarah Foster covers the Federal Reserve, the U.S. economy and economic policy. She previously worked for Bloomberg News, the Chicago Tribune and the Chicago Daily Herald.
Edited by
Senior wealth editor