The Punch Bowl’s Long Good-Bye

The Punch Bowl’s Long Good-Bye

With the arrival of summer and the improving post-COVID re-opening well underway—despite the recent concerns about the Delta variant—there is increasing optimism in the air. People are planning social events and booking travel again. Employees are heading back to work, and consumers are spending. Economic data generally looks strong, and prices are on the rise. At this point in the economic cycle, it is our view that it’s probably time for the Federal Reserve to begin pulling back that proverbial “punch bowl” and remove some of the emergency monetary stimulus measures that they introduced last spring.  

This “punch bowl” metaphor dates back to the 1950s and a speech made by William McChesney Martin, the Fed Chair at the time. In reference to raising interest rates to prevent excess inflation, Martin compared the Fed to a chaperone who “has ordered the punch bowl removed just when the party was really warming up.” While we can debate where we are in this current economic cycle, most people agree that we are past the “warming up” stage. 

Over the past year, the Fed has been very vocal about their intentions of “keeping the punch bowl full” and “making it a party worth attending.” Interest rates have been pegged at zero, and the Fed has been buying $120 billion in bonds each month since last spring. The Fed has also intervened in private markets and introduced other emergency liquidity facilities, which the market needed during moments of extreme stress last year. Over the past year, the U.S. had never seen a more accommodative monetary policy in its history.

While policy remains supportive today, there is a sense that peak support is passing. Instead of abruptly pulling the plug on the party though, the Fed is trying to carefully tip toe away from its hosting responsibilities. Let’s just say they are “watering down the punch” and trying to shrink the size of the remaining bowl. In an age of critical forward guidance and an over-communicative Fed that wants to avoid a “taper tantrum,” monetary policy normalization is most likely going to be a gradual process. For example, at the June FOMC meeting, the Fed informed us they are “talking about talking about raising rates.” This was big news last quarter because they brought forward their timeline for raising rates from 2024 to 2023. And yet, the bond market reaction has been a head scratcher as longer-term interest rates actually declined in response to this more hawkish Fed.

In recent commentary, Chair Powell continues to believe current higher inflation will be transitory and they are still “a ways off from reaching the standard of substantial further progress.” Even before the Fed raises interest rates, they will need to begin tapering their monthly bond purchases. While there is no firm consensus among FOMC members on the timing of tapering yet, we anticipate tapering will begin late this year or early next year. The last time the Fed tapered bond purchases was back in 2014, and the process started slowly and lasted around 10 months.

As the Fed begins to normalize monetary policy this time around, we anticipate it will be a slow and gradual process that could lead to increased volatility. We anticipate interest rates will rise as we get closer to the Fed’s tapering of asset purchases, and we will continue to manage portfolios accordingly. As the Fed’s emergency stimulus measures begin to abate, we view this is a positive development. In our view, markets will readjust, and we will find ourselves in a healthier position with a more normalized interest rate environment and improved opportunities for income in the future.

Source: https://www.federalreserve.gov/monetarypolicy.htm

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