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Taper talk at the Fed – Are we there yet?

There appears to be tension among US monetary policy-setters over the timing of the first steps in the process towards trimming the extraordinary central bank support unleashed as the pandemic raged, the economy had to be shut down, employment was hit hard and inflation all but swooned.

The minutes of the latest meeting of policymakers show that some of them “suggested that if the economy continued to make rapid progress, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases” under the Federal Reserve’s trillion dollar quantitative easing (QE) pro-growth and pro-inflation programme. [1]

This appears to run counter to chair Jay Powell’s emphatic assertion that it was not time to start talking about tapering QE yet at the press conference after the same Fed meeting.

A gentle nudge?

Setting aside the apparent divergence in view between Powell and some of his colleagues, the Fed has repeatedly said that it would provide lots of advance warning about the taper process.

Did we get a warning already? The comment quoted above is a caveated, conditional statement: “if the economy continues to make rapid progress…, it might be appropriate”. Perhaps. Such a comment can be seen as the gentlest, earliest step the Fed could take on a journey toward tapering without generating a 2013-style taper tantrum reaction on the markets.

Those pushing for an early start to the taper discussion will have done so either because of concerns over asset price valuations and financial stability, or inflation expectations.

Concerns about financial stability

The minutes show that there is concern about low interest rates leading to reach-for-yield behaviour that might threaten financial stability.

With corporate bond spreads tight and Powell having gone so far as to describe the stock market as having signs of ‘froth’, it’s pretty easy to imagine some on the Fed worrying that USD 120 billion of QE every month might push asset prices up further, increasing the risk of a disruptive adjustment.

However, the counter-argument from the more dovish Fed members is likely to be that the hawks should be arguing for tightening capital/regulatory policy instead of monetary policy.

Inflation – That cautious feeling

In the discussion of the inflation outlook, some policymakers appear to wonder whether the current supply disruptions could last until 2022. That might continue pushing up inflation into next year.

In and of itself, that should have no implications for monetary policy: Higher prices are the mechanism for transferring income from purchasers of goods and services in short supply to their producers. However, if those purchasers attempt to resist that transfer of income by bidding up wages or other prices, that becomes a potential issue for monetary policy.

Put another way, the Fed’s new average inflation targeting (AIT) framework is intended to help nudge inflation expectations slightly upward relative to their pre-pandemic levels, but policymakers do not want to see a series of supply shocks suddenly lead to a major surge in inflation expectations.

Look for tapering steps by next January

Ultimately, data on the shape of the US economy will decide when the taper discussion starts. So far, the jobs numbers have not played ball: The labour market has made only minor progress since December 2020 when the Fed said ‘substantial further progress’ was needed for it to taper QE.

The poor employment report for April will have surprised those pushing for an early start to the taper conversation. They will be hoping the May jobs report comes in strong. That would set the committee up for a first discussion on tapering QE at June’s policy meeting. But if that hope is not realised, the hawks will have to wait until at least July, and perhaps even the autumn.

Once the Fed starts discussing a policy change, it is likely to take six months (or more) to turn into actual measures on the pace of bond purchases. There is no single instrument that gives a clean read on when markets currently expect the taper to begin.

However, short-term interest rate futures are pricing a significant probability of an interest rate rise before the end of 2022, so a failure for the taper to get underway by the January policy meeting would likely be a dovish surprise.

Are inflation expectations well anchored? Read this blog article on why any rise in inflation will be temporary, paving the way for ‘lower for longer’ on interest rates.

[1] The Fed's balance sheet ballooned after its 15 March 2020 announcement to carry out quantitative easing to increase the liquidity of US banks. It reached USD 7.81 trillion as of 5 May 2021. This measure was taken to increase the money supply and stimulate economic growth in the wake of the damage caused by the COVID-19 pandemic. Source: • COVID-19: impact of QE on Fed balance sheet 2021 | Statista

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