Fed is about to shift gears, but this time it may be different

Federal Reserve officials, increasingly confident the US economy is recovering fast from the pandemic-induced recession, have begun telegraphing an exit from the central bank’s extraordinarily easy monetary policy that so far is smoother and signaled to be speedier than when the reins were tightened after the last crisis.

Though policymakers have yet to agree on a plan, most expect that by the end of 2023 they will have raised the Fed’s benchmark short-term interest rate at least twice from the current near-zero level, forecasts published by the central bank on Wednesday show. Eight of the 18 policymakers see at least three rate hikes by then.

And though the Fed made no forecasts about its $120 billion monthly bond-buying program – which, along with rock-bottom interest rates, is keeping borrowing costs low and supporting economic growth – policymakers have said they will phase out the program before they begin raising rates.

Following the 2007-2009 financial crisis and recession, it was a full two years from the formal announcement in December 2013 of the bond-buying taper to the first interest rate increase. The taper wrapped up in 10 months and left a still-wobbly economy more than a year to prepare for higher borrowing costs. It was another full year between the first and second rate hikes.

This time, the Fed is most likely to launch the taper in January, according to a Reuters poll. Getting two rate hikes in by the end of 2023, as the forecasts showed on Tuesday, would substantially shorten the runway for the handoff from the taper to a rates liftoff, and the rate increases also are projected to come more quickly.

That’s not to say the shift in gears, from easing policy to slowly tightening it, is imminent.

The economy, Fed Chair Jerome Powell noted on Wednesday, still has “a ways” to go before it will have healed enough for the Fed to start paring the monthly bond purchases. And the timing of the rates liftoff isn’t even in the conversation, he said.

The Fed’s rate projections have made half-point jumps before, particularly in the 2014-2016 period when the central bank was beginning its exit from the policies used during the earlier financial crisis.

But at that point the central bank was also in the middle of a consequential rethink about how the economy worked, and in particular was steadily lowering its estimates of the long-run “neutral” rate of interest used to assess whether monetary policy is encouraging or discouraging economic activity. Those markdowns were driving estimates of its own policy rate lower as well.

This time, the Fed is more directly shaping its outlook to immediate economic conditions.

The main message from the Fed’s new forecasts, Powell told reporters after the end of the central bank’s latest two-day policy meeting, is that “many participants are more comfortable that the economic conditions in the (policy) committee’s forward guidance will be met somewhat sooner than previously anticipated.”

That, he added, “would be a welcome development: If such outcomes materialize, it means the economy will have made faster progress toward our goals.”

It would also be different from the last time around, when the economy as it recovered from the financial crisis regularly fell short of the forecasts that Fed policymakers penciled in each quarter.

Powell said the Fed would, starting at its meeting next month, begin to assess whether the economy has made enough progress toward its 2% inflation and full employment goals to justify reducing bond purchases, and would be “orderly, methodical and transparent.”

That’s yet another departure from the blueprint used last time.

“In 2013, it was the Fed initiating the conversation about taper, and the markets were taken off guard,” said Ellen Gaske, an economist at PGIM Fixed Income. This time, she said, “it’s clear that markets and the Fed are in large part on the same page.”

That has occurred even though the Fed’s forecasts represent such a big turnaround from March, when the bulk of the policymaking committee saw no rate increases until 2024, and most of Wall Street expected the Fed would continue its $120 billion in monthly asset purchases through at least the end of 2021.

“We still think it would be pretty rushed to see tapering begin before December,” JPMorgan economist Michael Feroli wrote on Wednesday.

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