With the focus on a taper, five questions for the Fed

© Reuters. FILE PHOTO: The Federal Reserve building is set against a blue sky in Washington, U.S., May 1, 2020. REUTERS/Kevin Lamarque/File Photo

By Karen Brettell

(Reuters) - Investors are fixated this week on the Federal Reserve’s policy meeting as the U.S. central bank approaches the final quarter of the year, when it is expected to begin paring back its unprecedented level of bond purchases as the first step toward normalizing monetary policy.

Although investor expectations are high that tapering will start in 2021, there is still much uncertainty around when the Fed will announce and subsequently reduce bond purchases. The same applies to when it will then hike interest rates for the first time since 2019, before the pandemic led it to slash rates to zero.

Here are five of the main issues investors will be watching at the conclusion of the Fed’s two-day meeting on Wednesday.

BOND TAPERING – HOW SOON IS NOW

Most Fed officials have voiced support for a reduction in bond purchases beginning this year, so long as the labor market continues to improve.

While it is possible that the Fed will announce a taper of its $120 billion in monthly purchases of Treasuries and mortgage-backed securities (MBS) this week, with purchases to be reduced as soon as November, recent weakness in economic data has reduced the likelihood of such a move.

Jobs data for August came in well below expectations, while red-hot inflation boosted by businesses reopening after COVID-related shutdowns is showing signs of moderation.

Investors are focused on any new signals on when a taper may begin, and whether the move will be pegged to concrete improvement in data, including employment. The Fed’s early November meeting will take place before it sees the employment data for October, which may leave policymakers hesitant to decide before December.

The pace of a reduction will also be key for how long it will take to end the quantitative easing, which is expected to conclude before the Fed raises rates. Fed Chairman Jerome Powell, who is due to speak after the meeting statement, may also indicate that the Fed could speed up, slow down or stop any taper if economic conditions deteriorate.

(Graphic: Fed balance sheet, https://fingfx.thomsonreuters.com/gfx/mkt/byprjlqozpe/Fed%20balance%20sheet.JPG)

THE PATH OF RATE HIKES

The Fed has been careful to try to separate any timetable for reducing bond purchases from lifting rates from zero for the first time since March 2020, but that may not be as easy as some think.

If employment continues to improve and inflation stays above target, the conditions for tapering may also be viewed as the same for lifting rates.

The Fed spooked investors in June after policymakers said they were forecasting two interest rate hikes in 2023.

The “dot plot,” where Fed officials place their projections for the federal funds rate, this month will update whether these expectations have changed. It will also offer the first peek at Fed officials’ expectations for 2024.

If rate projections through this date come in more hawkish than expected, then intermediate-dated note yields, which are sensitive to possible rate hikes in this time frame, could rise.

Fed funds futures are priced for the first interest rate increase to occur in March 2023.

(Graphic: Fed Dot Plot, https://fingfx.thomsonreuters.com/gfx/mkt/xmvjoknobpr/Fed%20Dot%20Plot.JPG)

WILL HIGH INFLATION PROVE TRANSITORY?

The key argument underpinning when rates may be raised is whether the Fed will be able to wait to see the economic improvement it wants before tightening, or if spiraling price pressures will force it to act.

Recent softening in prices will bolster Powell’s argument that high inflation will prove transitory. The inflation-linked swap curve is downward sloping, reflecting expectations that annual increases in the Consumer Price Index have peaked.

But it is not clear when supply chain disruptions that have helped push up overall prices will ease. Plus, new restrictions from the potential spread of coronavirus variants are a wildcard on whether inflation will continue to accelerate or stay at elevated levels.

The economic projections released on Wednesday are likely to show a wide range of inflation forecasts from policymakers who may differ on whether inflation risks are to the upside or downside.

(Graphic: Inflation, https://fingfx.thomsonreuters.com/gfx/mkt/myvmnoanjpr/Inflation.JPG)

ECONOMIC PROJECTIONS

Policymakers’ economic projections for growth and employment, released with the dot plots after the March, June, September and December meetings, will offer insight on whether policymakers are concerned that growth and employment may lag inflation, leaving the Fed in a bind over how to normalize policy.

Some investors are concerned that the U.S. economy could enter a period of stagflation, in which pricing pressures rise even as growth is sluggish.

A Bank of America (NYSE:BAC) report released earlier this month showed that investors have swept into assets that are perceived to perform better in such an environment, when typically very few asset classes perform well.

(Graphic: Payrolls, https://fingfx.thomsonreuters.com/gfx/mkt/gkvlgwlgapb/Payrolls.JPG)

PROPORTIONAL MBS AND TREASURY REDUCTIONS

Since the pandemic started, the U.S. central bank has been buying $80 billion in Treasury securities and $40 billion in mortgage-backed bonds per month.

Speculation that the Fed may reduce purchases of mortgage-backed securities before, or at a faster pace, than Treasuries has faded as Fed officials play down the prospect that MBS buying has contributed to record housing prices across the country.

Powell said in July that he expects the Fed to wind down the purchases of Treasuries and MBS at the same time.

Still, investors will watch for any indications that this policy is being reconsidered.

(Graphic: MBS, https://fingfx.thomsonreuters.com/gfx/mkt/zdvxodxogpx/MBS.JPG)