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Here's why you should care the Fed is set to announce it's tapering its bond-buying stimulus

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The Federal Reserve, in a sign of how far the U.S. economy has  recovered from the COVID-19 recession, is likely to announce this week that it will scale back the bond-buying stimulus it began in the early days of the health crisis.

The move could reveal the approach the Fed is taking to a recovery that has become more complicated as inflation picks up and growth slows.

Normally, economic growth and inflation move together. The Fed lowers interest rates to stimulate borrowing and jump-start economic activity and raises them to curtail growth and head off a spike in inflation.

The Fed isn’t likely to raise its key short-term interest rate from near zero at a two-day meeting that starts Tuesday, or anytime soon.

If Fed policymakers lay out a plan to reduce the bond buying more rapidly than anticipated, it probably will be viewed as a signal they could hike rates earlier and faster than projected next year to rein in a surge in consumer prices.

“Markets are betting the Fed will raise rates more quickly,” says Kathy Bostjancic, chief U.S. financial economist for Oxford Economics.

Aggressive rate increases would mean higher borrowing costs for consumers on everything from mortgages and car loans to credit card bills.

'Substantial' strides to full employment

The central bank has been buying $80 billion a month in Treasury bonds and $40 billion in mortgage-backed securities to hold down long-term rates, such as for mortgages, and spur more economic activity.

It said it will continue the purchases at that pace “until substantial further progress has been made toward” its goals of full employment and 2% inflation. 

Full employment occurs when virtually every able-bodied person who is willing to work at the prevailing rate of wages is working.

Fed Chair Jerome Powell said the inflation target has been met – prices rose 4.4% annually in September, according to the Fed’s preferred measure – and progress has been made toward full employment.

The unemployment rate has fallen to 4.8% from 6.7% in December, though that’s still well above the pre-pandemic level of 3.5%, which marked a half-century low.

Fed officials suggested they’ll probably taper down the Treasury and mortgage bond purchases by $10 billion and $5 billion, respectively, each month, starting in November. Under that scenario, the bond buying would end next June.

The announcement of the tapering itself isn’t likely to push up interest rates, which rose in anticipation of the move as well as higher inflation, Bostjancic says. Since late last year, 10-year Treasury yields have climbed from 0.93% to 1.56%, and the average 30-year fixed mortgage rate has increased from 2.74% to 3.14%.

Low mortgage rates helped home buyers as prices have continued to rise amid a shrinking supply of homes.

Higher bar for rate hikes

By contrast, the central bank said it will keep its key interest rate near zero until the economy returns to full employment and inflation has risen above its 2% goal “for some time.”

Powell stressed that’s a higher bar than what’s required to wind down the bond buying, and the end of bond purchases doesn’t mean the start of rate hikes.

He said the Fed is unlikely to nudge rates higher while it’s still snapping up bonds to juice the economy.

Investors don’t seem to be buying Powell’s efforts to totally separate the bond program from rate increases. Fed funds futures markets predict two rate hikes next year and as many as three in 2023. In September, Fed policymakers predicted no more than one rate increase next year.

Inflation surge

Markets are reacting to a leap in inflation triggered largely by the reopening economy and COVID-19-related supply chain bottlenecks that have led to myriad product shortages.

Powell and other Fed officials said they believe the sharp price gains are temporary, noting they’ve been driven by higher costs for goods and services affected by the pandemic, such as airfares, hotel rates and used cars.

The most recent consumer price index showed inflation has spread to a broader range of items, especially rent, food and energy. 

The average price for a gallon of regular unleaded gas in the USA has increased by $1.25 to $3.40 compared with one year ago, according to AAA. In California, the average price of unleaded gas is $4.59 a gallon.

“The supply-side constraints have actually gotten worse in some respects," Powell said during a virtual conference. "The risks are clearly now to longer and more permanent constraints and thus higher inflation.”

In a post-meeting statement, the Fed isn’t likely to change its view that the inflation bump largely reflects “transitory factors.” Such a change would raise alarm bells and signal an inclination to faster rate increases, Bostjancic says.

Morgan Stanley expects the Fed will add that the supply snags “may keep inflation elevated well into next year.”

Bond stimulus could be cut faster

Economists don’t expect the Fed to veer from its plan to trim the bond purchases by a total $15 billion each month.

Barclays expects the Fed will say the tapering “is not on a preset course,” suggesting it could be accelerated if supply kinks linger and inflation proves more stubborn.

That's simply “boilerplate” language, Barclays says.

Bostjancic says it may make jittery investors more nervous, potentially pushing market-based interest rates higher and dinging stock prices. It would be less disruptive if Powell simply notes the Fed's flexibility to adjust the bond purchases during his news conference, she says.

If the supply snags and inflation don’t ease noticeably by the middle of next year, as many economists expect, the Fed could scale back the bond purchases more rapidly and shift to rate hikes shortly after, Bostjancic says.

After all, she says, since rate hikes and cuts work with a lag, the Fed could make a mistake by raising rates too early – just before the supply problems ease and prices fall. That could push down inflation too sharply and hinder an economy projected to slow next year.