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Given inflation developments, there’s more tapering ahead

Key messages

  • The target for the federal funds rate remains 0-to-0.25%.
  • The U.S. Federal Reserve continues to reduce asset purchases.
  • U.S. growth revised down for 2021, but up for 2022.

In its final regularly scheduled meeting of 2021, the U.S. Federal Open Market Committee (FOMC) unanimously agreed to hold the target for the federal funds rate at 0-to-0.25% – a decision that was widely expected. Additionally, it announced it would accelerate tapering by reducing asset purchases by US$20 billion for Treasury securities and US$10 billion for agency mortgage-backed securities.

Tapering to continue

The U.S. Federal Reserve (Fed) also released its latest economic projections. Compared to its expectations from September, growth was pushed out from 2021 (revised down from 5.9% to 5.5%) to 2022 (revised up to 4.0% from 3.8%). This can be attributed to the stubborn pandemic-related demand and supply imbalances – and its contribution to elevated inflation – and the ongoing uncertainties brought about by the virus and its new variants. 

With strong policy support and robust vaccination progress, economic activity and employment have continued to strengthen. Given this improvement, the Fed will continue with its tapering program.

Despite the planned reductions, the FOMC will still increase its holdings of Treasury securities and agency mortgage-backed securities by at least US$40 billion and US$20 billion respectively in January.

Unchanged is the Fed’s stance on the pace of reductions – it expects similar reductions in the pace of purchases each month after that. However, it is prepared to adjust the pace if the outlook changes as pandemic-related risks remain.

Tapering is now expected to finish in March 2022, potentially setting things up for two-to-three 0.25% rate hikes next year. We are aligned with this expectation.

Inflation likely to remain elevated in 2022

While the Fed still believes inflation will normalize towards its 2.0% target, inflation was revised materially higher for 2021 and 2022 in its latest projections. This indicates that the elevated inflation we’re experiencing now is more persistent than previously thought. According to the Fed’s projections, inflation will end 2022 well above target, at 2.6%, before trending towards 2.1% by the end of 2024.

Markets welcome the news

We saw equity markets and U.S. bond yields move higher and the U.S. dollar trade lower relative to the Canadian dollar following the announcement.

At this time, we remain overweight equities relative to fixed income. However, it is important to note that this overweight has trended downwards in recent quarters as conditions that pushed stocks higher have eased.

Within our fixed income positioning, we remain short interest rate risk (duration) overall. We have recently removed our yield curve flattening position as further upside appears limited. Within equities, we remain overweight developed markets, (particularly North American equities) relative to emerging markets. For more information, please contact your MD Advisor*.

The Fed’s next interest rate announcement is scheduled for January 26th, 2022.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting, or similar professional advice nor is it intended to replace the advice of independent tax, accounting, or legal professionals.

 

About the Author

RICHARD SCHMIDT, CFA, is an Associate Portfolio Manager with the Multi-Asset Management team. His primary focus is MD’s North American equity funds and pools.

Profile Photo of Richard Schmidt