A little over a month ago, the Federal Reserve announced plans to gradually unwind (“taper”) their quantitative easing programs. The plans put forward were to trim the monthly bond and mortgage security purchases by $15 billion per month, effectively ending the QE program by June 2022.
By the end of November, however, those plans had changed.
In a testimony to the Senate Banking Committee on November 30th, Federal Reserve Chairman Jerome Powell admitted that “pricing increases have spread much more broadly” than anticipated in the economy, and that the Fed “didn’t predict supply-side problems.” In other words, inflation is running hotter-than-expected for longer-than-expected, and the Fed is responding by accelerating the taper and potentially setting the stage to raise interest rates on a faster timeline next year.1
From an investment standpoint, a more hawkish Federal Reserve is often believed to be problematic. A reduction in monetary stimulus, coupled with rising interest rates, surely cannot be good for stocks, right?
A quick review of recent history can help us address this question. There is only one previous instance of Fed tapering, in 2013, and the stock market endured some short-term selling pressure in the midst of the QE’s unwinding. But the selling pressure did not last very long. From the time Ben Bernanke announced QE would be reduced (summer 2013) to the actual end of QE (fall 2014), the S&P 500 went up over +20%.2
The Fed then started raising interest rates in December 2015, pushing the fed funds rate from 0.5% in December 2015 all the way up to 2.5% by December 2018. As readers can see from the chart below, Fed tightening during the last bull market caused a few blips and pullbacks, but QE tapers and rate hikes were not powerful enough to prevent the stock market from pushing higher.
The S&P 500 Over the Last Decade
Source: Federal Reserve Bank of St. Louis3
I similarly do not expect a shift in the Federal Reserve’s current messaging and policy to have a meaningful effect on stocks. The stock market has long known about the Fed’s plans to gradually remove monetary policy stimulus, and a slightly accelerated, well-telegraphed timeline for policy changes should not serve as a negative surprise.
In fact, markets may even welcome an accelerated taper – since QE purchases put downward pressure on long-dated U.S. Treasury bond yields, QE is effectively flattening the yield curve and squeezing bank profits in the process. If an accelerated taper allows longer duration bond yields to move higher while short-term interest rates remain close to zero, it could spur more bank lending – a good outcome for the economy.
As for the Fed moving up their timeline for interest rate increases, I think it is important for investors to remember that bull markets tend to end after the Fed’s last rate hike – not their first one. As readers can see in the S&P 500 chart above, the U.S. stock market can continue to do well even as the Federal Reserve engages in fed funds rate increases. That process may begin in 2022, but it does not mean the bull market has to end as a result.
Bottom Line for Investors
In my view, the Federal Reserve’s shifting message and policy is in response to a good problem. In the words of New York Fed President John Williams, the U.S. economy is “roaring back,” and supply/demand imbalances are putting pressure on prices. Demand is above pre-pandemic levels, and supply can’t keep up. I don’t see this as a permanent problem.
Even still, the Fed is probably right to take some action, even if only for optics. A slightly accelerated taper timeline and the possibility of rising rates next year are not likely to move the needle on inflation at all, in my view, and I concurrently don’t see much effect of this tightening on the economy or stocks. I’ve written before that corporate earnings and economic growth matter more than the Fed, and I do not think a slight shift in the Fed’s messaging and policy will affect either in the coming year.