Fed to Shift Gears Sooner Rather Than Later, BofA Says

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The Federal Reserve may start tapering its asset purchases sooner rather than later, paving the way for an interest rate hike in the second half of 2023, according to analysts at Bank of America (BofA). 

The Fed has repeatedly said that it must see “substantial further progress” toward its employment and inflation goals before easing up on its efforts to stabilize the economy. Since the pandemic began last year, the Fed has kept interest rates near zero and bought back Treasuries and agency mortgage-backed securities (MBS) to help keep the economy flush with cash. 

That, along with three massive stimulus bills, staved off a potential liquidity squeeze and ensured that banks would continue to lend money to people who needed it to survive the financial blows of the pandemic. 

BofA analysts now say that sufficient progress will be achieved this year for the Fed to start thinking about tightening monetary policy, according to a research report released last week. It maintains that the government will report several months of strong employment data during summer and early fall, and that the economy will reach pre-pandemic levels of employment by the end of 2021. That will be enough for the Fed to start signaling its intention to tighten the money supply, starting with “tapering,” said BofA.

Tapering, or cutting back on purchases of Treasuries and MBS, will likely occur over 10 to 11 months, concluding near the end of 2022, BofA said. When the Fed reduces the amount of debt it purchases on the open market, money supply tightens because the government is no longer injecting as much cash into the system.

BofA said that to keep inflation in check, the Fed will follow up its tapering with an initial interest rate hike, likely in the second half of 2023, which would make borrowing more expensive and thus, less attractive.

“The set of conditions for the Fed to taper are different than for hikes: in order to taper, we believe the Fed wants to see a reversal of the COVID drag on the labor market but to hike, the Fed needs to observe conditions for an inflation overshoot,” BofA wrote. This puts the spotlight on labor market data for the former and inflation for the latter.”

The Fed has committed to communicating “well in advance” when it intends to start taking its foot off the gas for the economy, and so far it has given no such indications. BofA said it expects that time will come in June, during that month’s meeting of the Federal Open Market Committee (FOMC), the policy arm of the Fed, with “a number of the more hawkish Fed presidents setting the stage for exiting from asset purchases given what will likely be very strong growth and inflation data.”

BofA’s rate hike prediction is ahead of the FOMC’s expectation to keep rates flat through the end of 2023.