Fed takes first steps toward tightening policy without setting off a major market panic

Published Wed, Jun 16 20216:57 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Key Points

Fed officials surprised markets after their two-day meeting with a forecast for two rate hikes in 2023, after previously predicting none.
The Fed also said it discussed tapering its bond program, as expected, but it provided no timeline on when it would begin the process.
Stocks fell and Treasurys sold off as the Fed made its first baby steps toward tightening easy policies it has had in place since the pandemic

The Federal Reserve's hawkish tone sent stocks lower and bond yields higher, but for now, the central bank has managed to inch closer toward tighter policy without triggering massive market angst. Even so, concerns remain about whether inflation is really just fleeting, and whether the central bank can continue to manage the path away from its extraordinary policies smoothly. The Fed surprised investors Wednesday by including two interest rate hikes in its economic forecast for 2023 after having none in its last forecast in March. But it did not give any time frame on how long it will be before it begins to trim its bond purchases. "You've got an oil tanker. You've got to turn the wheel way before, and then the ship starts turning well down the way. That's what we saw," said Vincent Reinhart, chief economist at Mellon. Stocks were lower, with the Dow losing 265.66 points, or about 0.8% at 34,033.67. Treasury yields, which move opposite price, moved higher. The 10-year yield jumped to nearly 1.58%, from 1.48% earlier in the day. Fed Chairman Jerome Powell said the central bank, as expected, has had preliminary discussions about paring back its $120 billion monthly bond-buying program, but said the decision on when it will start reducing purchases depends on economic progress. Economists expect Fed officials to make a more definitive announcement about the bond purchases at their annual Jackson Hole symposium in late August. "They're reading the situation that markets are trying to extract from them signs of policy firming. And so they can ride that," said Mellon's Reinhart. "They can ride that by slow walking tapering and making it very clear tapering comes first, and they have to see more economic progress." Not a repeat of the 2013 "taper tantrum" Reinhart said this is different than when former Fed Chairman Ben Bernanke surprised the markets by announcing a tapering in 2013, resulting in a market rout known years later as the " taper tantrum ." This time market pros were expecting the Fed to pull away from its easy stance. While the Fed's statement was viewed as hawkish Wednesday, strategists say Powell managed to sound more dovish. "Now people are more worried about inflation, and he is leaning into that by saying 'yes, it's higher than we thought, but it is transitory, and we have lots of tools to tackle it if it becomes a problem,'" said Reinhart. He noted that Fed officials did increase their median forecast for inflation in 2021 by a percentage point to 3.4% for personal consumption expenditures inflation , but they did not build in higher inflation forecast into their longer term projections. You've got an oil tanker. You've got to turn the wheel way before, and then the ship starts turning well down the way. chief economist at Mellon Vincent Reinhart, Rising inflation readings have become a worry for investors. Producer prices jumped 6.6% on an annual basis in May, the highest in history. Consumer prices were up 5% in May. The tapering of the Treasury and mortgage purchases, anticipated to take place over months, is important since it would be the Fed's first step toward removing easy policy it put in place to help the economy through the pandemic. It is also a signal that the Fed is looking to the day when it could raise interest rates, which is expected after the bond program is tapered to zero purchases. Powell, during the press briefing, sought patience from the public. "We have to be humble about our ability to understand the data. It's not a time to try to reach hard conclusions about the labor market, about inflation, about the path of policy," he said. "We need to see more data; we need to be a little bit patient." Downplaying the dot plot? Market pros took as a positive another comment from Powell that the Fed's so-called dot plot interest rate forecast is not all that important. This prediction is presented as a chart of anonymous dots for each Fed official's view of where interest rates will be through 2023. "He talked down the importance of the dot plot and so forth," said Ed Keon, chief investment strategist at QMA. He said the Fed is slowly moving the market along to the idea of tightening. "I don't think it's positive, but I don't think its the end of the world either...I think you want the Fed to tighten. The fed tightening doesn't have to be bad for stocks. If the Fed tightens policy... and keeps inflation from getting out of control, the market can do just fine," Keon said. "It's when Fed policy is ineffective then it's negative," he added. "This is going to be a challenge for the Fed and the market in the next couple of years. There are going to be inflationary pressures, and none of us know whether they're going to be transitory or not." Keon said for now he's positive on stocks and is sticking with the market. "We're overweight stocks in our asset allocation portfolios, and we'll stay there for now. We always keep our eyes open and if we become convinced inflation is going to become persistent I think we'll change our mind," said Keon. "You're going to have profits up 40% this year." Even though nobody knows whether inflation will keep moving higher, he said Powell's approach to it was favorable. "It shows the Fed is aware of rising inflationary pressures," Keon said. "This gives you more confidence that the Fed is not stuck in this rut and they're going to keep rates at zero and buy bonds until the economy gets really out of control." He said Powell did a good job avoiding pitfalls at his press briefing. "He handled the press conference extremely well," Keon said. "It could have been a strain to explain this small transition." NatWest's Brian Daingerfield said the markets had been worried the Fed would do more than it did. "We're in an environment where growth is strong, inflation is high at the moment," he said. "Clearly the market came in thinking you get a little more, and instead we got it in line. They're tiptoeing toward tapering." He said it's a positive and sign of strength that the Fed put two hikes in 2023 and yet Powell is driving home that the Fed sees inflation as temporary.

Jerome Powell, Chairman of the U.S. Federal Reserve, testifies before the Select Subcommittee on the Coronavirus Crisis hearing in Washington, D.C., September 23, 2020.

Kevin Dietsch | Reuters

The Federal Reserve's hawkish tone sent stocks lower and bond yields higher, but for now, the central bank has managed to inch closer toward tighter policy without triggering massive market angst.

Even so, concerns remain about whether inflation is really just fleeting, and whether the central bank can continue to manage the path away from its extraordinary policies smoothly.

The Fed surprised investors Wednesday by including two interest rate hikes in its economic forecast for 2023 after having none in its last forecast in March. But it did not give any time frame on how long it will be before it begins to trim its bond purchases.

"You've got an oil tanker. You've got to turn the wheel way before, and then the ship starts turning well down the way. That's what we saw," said Vincent Reinhart, chief economist at Mellon.