Federal Reserve Chairman Jerome Powell indicated that the central bank is likely to begin withdrawing some of its stimulatory monetary policies before the end of 2021. However, the Chairman did note that he still sees interest rate hikes off in the distance. In the Fed’s annual Jackson Hole, Wyoming, symposium, Powell said the economy has reached a point where it no longer needs as much monetary policy support.
Thus, the Fed will likely begin cutting the amount of bonds it buys each month before the end of the year, so long as economic progress continues. Based on statements from other central bank officials, a tapering announcement could come as soon as the Fed’s Sept. 21-22 meeting. Despite this pivot, it does necessarily mean rate increases are looming.
This pivot in monetary policy by the Federal Reserve sets the stage for the initial reduction in asset purchases and downstream interest rate hikes. As this pivot unfolds, risk appetite towards equities hangs in the balance. The speed at which rate increases hit the markets will be in part contingent upon inflation, employment, and of course, the pandemic backdrop. Inevitably, rates will rise and likely have a negative impact on equities.
Jerome Powell stated, “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test,” He added that while inflation is solidly around the Fed’s 2% target rate, “we have much ground to cover to reach maximum employment,” which is the second prong of the central bank’s dual mandate and necessary before rate hikes happen.
The Fed looks at employment and inflation as benchmarks for when it will start tightening. Powell said that the “test has been met” for inflation while there “has also been clear progress toward maximum employment.” He said he and his fellow officials agreed at the July Federal Open Market Committee meeting that “it could be appropriate to start reducing the pace of asset purchases this year.”
The Fed committed to full and inclusive employment even if it meant allowing inflation to run hot for a while. “Today, with substantial slack remaining in the labor market and the pandemic continuing, such a mistake could be particularly harmful.” “We know that extended periods of unemployment can mean lasting harm to workers and to the productive capacity of the economy.”
The unemployment rate for July stood at 5.4%, down from the April 2020 high of 14.8% but still reflective of a jobs market that remains well off where it stood before the pandemic. In February 2020, unemployment was 3.5%, and there were 6 million more Americans working and 3 million more considered in the labor force.
Powell noted that the delta variant of Covid “presents a near-term risk” to getting back to full employment. Still, he insisted that “the prospects are good for continued progress toward maximum employment.” “Inflation at these levels is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary,” he said.
Consumer Price Index (CPI)
The Consumer Price Index (CPI) readings will become even more important and directly impact market movements and overall sentiment. These CPI reports are becoming more significant as these readings are used to identify periods of inflation. More robust the CPI readings will translate into a stronger influence on the Federal Reserve’s monetary policies and downstream interest rate hikes. The Federal Reserve is reaching an inflection point to where they will need to curtail their stimulative easy monetary policies as inflation, unemployment, and overall economy continue to improve. As a result, it is inevitable that their long-term monetary policy of low-interest rates and bond purchases will need to pivot to a scenario of higher rates to tame inflation. As a result, investors can expect increased volatility as these critically important CPI reports continue to be released through the remainder of 2021. Additionally, any notion of higher rates may spur investors to reduce exposure to equities.
CPI Market Jitters
Recent CPI readings have spooked the markets as these serve as a harbinger for the inevitable rise in interest rates. As investors grapple with the prospect of downstream rate increases, pockets of vulnerabilities throughout the market will be exposed. The overall markets have been on a blistering bull run since the November 2020 presidential election cycle. The overall markets as assessed by any historical measure have reached stretched valuations with record risk appetite. As real inflation enters the fray, these frothy markets will come under pressure and possibly derail this raging bull market. Moreover, the prospect of rising rates may introduce some systemic risk in the process. The confluence of rising rates, a hot housing market, and robust CPI readings may translate into real inflation rates that exceed the Federal Reserve’s target inflation zone over a sustained period of time. If these real inflation excursions drag on, these higher rates will be in the fold.
The CPI is an important economic readout as this is a measure of price changes of a basket of consumer goods and services used to identify periods of inflation. Mild inflation can encourage economic growth and stimulate business investment and expansion. High inflation reduces the buying power of the dollar and can reduce demand for goods and services. High inflation also drives interest rates higher while driving bond prices lower. Comparing the current cost of buying a basket of goods with the cost of buying the same basket a year ago indicates changes in the cost of living. Thus, the CPI figure attempts to measure the rate of increase or decrease in a broad range of prices (i.e., food, housing, transportation, medical care, clothing, electricity, entertainment, and services). As CPI numbers catch fire and remain elevated, the Federal Reserve will need to act to tame any runaway inflation, especially in a red-hot economic expansion that we’ve witnesses post-pandemic.
Tapering is now in the cards between now and the end of 2021. It’s going to be a tug-a-war between inflation, employment, and the delta variant backdrop. CPI reports will become more significant as these readings are used to identify periods of inflation. The recent CPI readings are resulting in a much stronger influence on the Federal Reserve’s monetary policies hence the taper guidance. Investors are speculating on when, not if the Federal Reserve will curtail their stimulative easy monetary as inflation, unemployment, and the overall economy continues to improve. Inevitably, low-interest rates will not be here indefinitely, and bond purchases will need to subside, thus pivoting to a scenario of higher rates in the intermediate-term. As investors grapple with the prospect of downstream rate increases, pockets of vulnerabilities throughout the market will be exposed when rate hikes are deemed on the horizon. As real inflation enters the fray, these frothy markets will come under pressure and possibly derail this raging bull market and introduce some systemic risk in the process. Investors can expect increased volatility as a function of key economic data, specifically the CPI readings.
Disclosure: The author holds shares in AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY, and USO. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.