The Federal Open Market Committee is expected to slowly moderate its accommodative policy in the two-day meeting on June 15 to 16, preparing markets for quantitative easing tapering in early 2022, according to Oxford Economics:
"While the FOMC will maintain a very dovish policy stance, we look for the committee to signal it will be "vigilant and closely monitor" inflation and inflation expectations. The gradual shift to a less extremely accommodative policy stance represents the initial pivot towards an announcement of QE tapering starting in early 2022, followed by two 25bps rate hikes in 2023."
The FOMC is a committee within the Federal Reserve System overseeing the nation's open market operations (OMO), the most frequent tool the central bank deploys to achieve its dual mandate: steady inflation and high employment.
By "steady inflation," the Fed usually means an inflation rate of 2%, though they have announced that that they are willing to accept a higher number for a sustained period this time around in order to support continued levels of high corporate debt.
The Fed defines high employment as a situation when unemployment is low, close to the "natural rate." That's the unemployment rate associated with full or maximum employment and steady prices, but they haven't explicitly come up with an exact number for it.
"Given the dynamic nature of the economy, it is not possible to know exactly how low the unemployment rate may be able to fall in a sustained way without causing excessive inflation," says the Fed's website. "The lowest level of unemployment that the economy can sustain changes over time as the jobs market changes. For example, employers may use new ways to search for workers, and workers may use new ways to find jobs. Even in good times, a healthy, dynamic economy will have at least some unemployment as workers switch jobs, and as new workers enter the labor market."
Simply put, maximum employment and the natural rate are moving targets. They change over time, together with the change of the economy and labor markets. That's why the FOMC holds regular meetings every five weeks, where its members sift through dozens of economic indicators to determine whether the economy is above or below full employment and decide whether monetary policy will be restrictive or accommodative.
When the economy moves closer to full employment and inflation rises above 2%, they should ideally go with restrictive monetary policies, taking liquidity out of the economy through the sale of assets in the open market.
By contrast, when the economy is below full employment and inflation below 2%, they go with an accommodative policy instead, adding liquidity through the purchase of assets in the open market.
Traditionally, open market operations were confined to the purchase and sale of assets with short maturity, allowing the Fed to control short-term interest rates. In the aftermath of the Great Recession, open market operations were extended to the purchase and sale of long-maturity assets, allowing the Fed to control short-term and long-term rates.
The Fed's policy has been accommodative over the past 15 months as the Covid-19 recession pushed the U.S. economy far below full employment and inflation stayed below 2%, meaning that the Fed has been adding liquidity in the economy by purchasing both short-term and long-term assets.
Now, the U.S. economy is recovering from the Covid-19 recession, and some inflation numbers are running at 5%. The FOMC may have to change its policy from monetary easing to monetary tightening, meaning tapering off the purchase of short-term and long-term assets and higher interest rates.
Wall Street isn't happy with this prospect, as higher interest rates could make high-risk assets less appealing to investors, and the amount and percentage of assets that qualify as high-risk has exploded in recent decades. That's why the Fed has to go slow, preparing markets for this prospect, beginning with the next meeting.
