Andrew Sheets: For the Fed, Are Tapering and Raising Rates the Same Thing?

One of our most controversial calls for 2022, that the Fed won’t hike interest rates next year, faces renewed scrutiny amidst high inflation, signals on tapering, and today's employment report.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, December 3rd at 2:00 p.m. in London.

We recently published our year ahead outlook for 2022 and right there on the cover, near the top, is one of Morgan Stanley Research's most controversial calls: that the U.S. Federal Reserve will not raise interest rates next year.

Over the last week, more than one investor has pointed to this report and asked if it still applies. After all, inflation has been high, a situation that tends to call for higher interest rates to cool the economy. And Federal Reserve officials have been increasingly vocal about the merits of slowing their bond buying, accelerating the so-called tapering, even more quickly than they originally intended. Seeing the economy is strong and in less need of that additional support.

If the Fed is going to slow down and then stop its bond buying more quickly, the argument goes, surely higher interest rates must be right around the corner. But there's an interesting phenomenon here. When you talk to most investors, they view both higher interest rates and fewer bond purchases as pretty similar things. Both actions, at their core, signal less central bank support for the economy and for markets.

But maybe, just maybe, central banks view the world a little differently. For them, buying any bond, even fewer of them, still represents additional support for the economy. But in contrast, increasing interest rates... well, that's different. That's not additional support, that's actively tightening monetary policy.

At the end of the day, this question is up to the central bankers. But if they do see a genuine distinction between these two actions - a difference that isn't necessarily as apparent to many investors - a faster taper may be able to coexist with a later first interest rate hike. That, at least, is how we see it at Morgan Stanley Research where our forecast is for exactly that - the Fed to accelerate the pace of its taper but not raise interest rates next year.

But there's one more wrinkle in this story. While we think the Federal Reserve will ultimately wait longer than most people expect to raise interest rates next year, there's little reason for them to make that clear now. Inflation is still high and probably won't start to fall for several months. Economic data has been strong and today's employment report showed yet another decline in the unemployment rate. We see little reason why the Fed would want to commit not to take action right now, even if we think that's what they ultimately might do.

Why does that matter? It will mean that in the near term, the Federal Reserve will appear to be taking support away from the economy and for markets. After extraordinary intervention to support markets and the economy, the central bank training wheels are coming off, so to speak, and this impact may be uneven. We think this creates the greatest challenge for highly valued growth stocks in the U.S. and emerging market assets and suggests that investors be patient before trying to buy both.

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