By Karen Brettell

NEW YORK (Reuters) – Investors are fixated this week on the Federal Reserve’s policy meeting as the U.S. central bank approaches the final quarter of the year, when it is expected to begin paring back its unprecedented level of bond purchases as the first step toward normalizing monetary policy.

Investor expectations are high for tapering to begin in 2021. However, it is uncertain when and how much the Fed will reduce its bond purchases. This is true for when the Fed will raise interest rates. It did so before the outbreak of the pandemic, which saw rates drop to zero.

Here are five of the main issues investors will be watching at the conclusion of the Fed’s two-day meeting on Wednesday.

BOND TAPERING – HOW SOON IS NOW

Most Fed officials have voiced support for a reduction in bond purchases beginning this year, so long as the labor market continues to improve.

It is possible the Fed may announce a decrease in the $120bn monthly Treasuries purchases and Mortgage-backed Securities (MBS), but recent economic weakness has made it less likely.

While August jobs data was below expectations, red-hot inflation that has been fueled by business reopening following COVID-related shut downs shows signs of moderated.

Investors pay attention to any signals about when the taper will begin. They also want to know if it is tied with a concrete improvement in employment data. The Fed’s early November meeting will take place before it sees the employment data for October, which may leave policymakers hesitant to decide before December.

It will be important to determine the pace at which a reduction is made, as this will affect how long it takes to stop quantitative easing. This will occur before the Fed raises interest rates. Jerome Powell (Fed Chairman) will speak following the meeting statement. This could indicate that Fed officials can speed up or slow down any taper, depending on economic conditions.

Graphic: Fed balance sheet: https://fingfx.thomsonreuters.com/gfx/mkt/byprjlqozpe/Fed%20balance%20sheet.JPG

THE PATH OF RATE HIKES

The Fed has been careful to try to separate any timetable for reducing bond purchases from lifting rates from zero for the first time since March 2020, but that may not be as easy as some think.

Inflation stays below target so if employment is improving, tapering conditions may be considered for raising rates.

In June, investors were frightened by Fed’s announcement that policymakers expected to announce two rate hikes in interest rates in 2023.

The “dot plot,” where Fed officials place their projections for the federal funds rate, this month will update whether these expectations have changed. It will also offer the first peek at Fed officials’ expectations for 2024.

The Fed could be more optimistic than anticipated regarding rate projections by this date. If that happens, intermediate-dated notes yields may rise. They are very sensitive to potential rate increases in this time period.

Futures on Fed funds are currently priced to allow for the March 2023 interest rate rise.

Graphic: Fed Dot Plot: https://fingfx.thomsonreuters.com/gfx/mkt/xmvjoknobpr/Fed%20Dot%20Plot.JPG

WILL HIGH INFLATION PROVE TRANSITORY?

When rates are raised, the key issue is how long the Fed can wait before tightening or whether spiraling inflation will make it have to raise them.

Recent softening in prices will bolster Powell’s argument that high inflation will prove transitory. Inflation-linked swap curves are downwardly sloping. This is due to expectations of annual increases in Consumer Price Index.

However, it’s not known when the supply chain disruptions which have pushed up prices overall will cease. New restrictions due to the spread of coronavirus variants could be a factor in whether inflation continues to rise or stays at high levels.

On Wednesday, the economic projections will show that policymakers may have different views on how inflation risk is going to be handled.

Graphic: Inflation: https://fingfx.thomsonreuters.com/gfx/mkt/myvmnoanjpr/Inflation.JPG

ECONOMIC PROJECTIONS

Policymakers’ economic projections for growth and employment, released with the dot plots after the March, June, September and December meetings, will offer insight on whether policymakers are concerned that growth and employment may lag inflation, leaving the Fed in a bind over how to normalize policy.

Investors are worried that the U.S. could experience a period where prices rise while growth slows, causing stagflation.

An earlier Bank of America report (NYSE:) showed that many investors are now buying assets which they believe will perform better than others in this environment. This is a concern since it’s not common for asset classes to do well in these environments.

Graphic: Payrolls: https://fingfx.thomsonreuters.com/gfx/mkt/gkvlgwlgapb/Payrolls.JPG

PROPORTIONAL MBS AND TREASURY REDUCTIONS

Since the pandemic started, the U.S. central bank has been buying $80 billion in Treasury securities and $40 billion in mortgage-backed bonds per month.

As Fed officials downplay the possibility that MBS purchases have contributed to the record-breaking housing prices in the United States, speculation that the Fed might reduce its purchase of mortgage-backed securities has waned.

Powell indicated in July that Powell expects the Fed will end its purchase of Treasuries at the same moment as MBS.

However, any signs of a change in policy will be closely watched by investors.

Graphic: MBS: https://fingfx.thomsonreuters.com/gfx/mkt/zdvxodxogpx/MBS.JPG