Could politics influence Fed’s next big monetary decision?

No surprises from the US Federal Reserve (Fed) at its policy meeting. The long anticipated tapering of bond purchases will begin this month with the central bank trimming its asset purchases by $15 billion.

The Fed has said it will be flexible in adjusting the pace of the taper, dependent on economic data. At this stage, however, there is little reason to doubt that asset purchases will be reduced from the current pace of $120 billion per month to zero by the middle of 2022.

The question now turns to when interest rates will rise. The market is looking for a swift response with rates rising in Q3 next year and then again in Q4. However, Fed chair Jerome Powell was in no mood to stoke tightening expectations. He continued to describe the outlook for inflation as “transitory” and said the central bank would be “patient” in withdrawing stimulus.

While we expect the US economy to firm in Q4 this year, there is considerable uncertainty as to how growth and the labour market will evolve once the pandemic passes. Inflation is likely to slowly ebb, but the biggest constraint on an early Fed rate hike is likely to be political.

With the mid term elections looming, the hurdle for raising rates is high. The central bank may be independent, but its policymakers have always been wary of putting their heads above the parapet at such times. Consequently we would expect Powell to wait until the elections are over and raise rates in December next year.

Of course, it may not be Powell who is chair at that time. President Biden will decide soon on whether Powell remains in post when his current term expires. From a rate perspective though this should not change the view as the main contender Lael Brainard is seen as being a policy dove.