Possible Fed tapering: a welcome necessary baby step, but it doesn’t mean much

 

*There is a good chance the Fed will make the widely anticipated announcement at the conclusion of its FOMC meeting tomorrow that it will commence tapering its purchases of Treasuries and MBS while continuing to reinvest the proceeds of maturing assets.  While such an announcement would be a welcome signal that the Fed is beginning to unwind its emergency monetary policies that were put in place in response to the pandemic and severe dysfunction in the U.S. Treasury market in March 2020, it is a tiny step that will have an imperceptible impact on the economy. 

*The Fed could delay this announcement if it continues to believe that there has not been “substantial progress” toward its maximum inclusive employment objective and concerns about the temporary negative impact on the economy stemming from the Delta variant.  However, it is clear that labor markets have improved significantly, and many labor market indicators in the aggregate and for different groups of people have recovered to levels consistent with mature stages of prior economic expansions (Updated expanded labor market dashboard indicates “substantial progress” has been made toward the Fed’s employment mandate).  In the context of high inflation and fundamental momentum in the economy and labor markets driven by unprecedented monetary and fiscal policy, delaying a tapering announcement would be unwise.

*While much attention has focused on when the Fed will taper, with the Fed’s balance sheet at $8.5 trillion, inflation persisting far above the Fed’s 2% longer-run target, and labor markets continuing their rapid recovery, tapering is old news; the more pressing issue is when will the Fed begin the lift-off on rates from their zero anchor. 

*On this critical point, Fed Chair Powell is expected to re-emphasize that the announcement to taper has no implications for when the Fed may begin raising interest rates.  Such a statement would highlight that, even with commencing tapering, the Fed will tip-toe toward raising rates and aim to maintain accommodative monetary policy.  This will be a relief to financial markets that crave monetary ease, but, amid high inflation and the forward momentum in the economy, it raises the risks of more persistent inflation and an undesired rise in inflationary expectations.  

*The Fed is tired of arguing that the rise in inflation is temporary and, based on its forecasts of inflation, is surprised at how much inflation has risen and how long it has persisted.  In December 2020, the median FOMC member forecast that PCE inflation would be 1.8% in 2021 (Q4/Q4). Its argument that inflation is temporary rests on the assessment that the rise in inflation has been due entirely to supply constraints.  A growing number of FOMC members are correctly becoming concerned that the strong rebound in aggregate demand, stemming from the unprecedented monetary and fiscal stimulus, has been a culprit in pushing up inflation, and, if aggregate demand continues to grow solidly, high inflation will persist.

*While the Fed has been very worried that tapering may jar financial markets, it has come around to believe that such a policy step is largely expected and built into market prices.

*In the Fed’s Summary of Economic Projections (SEPs), the FOMC will raise its forecast of inflation in 2021 (its projection of 3.4% in June has been superseded by higher inflation).  The FOMC may raise its 2022 inflation projection by a touch, but, in keeping with its argument that inflation is temporary, its forecasts of inflation decelerating back toward 2% in 2022 and 2023 will remain intact. 

*In June, the median FOMC member estimated that, based on each member’s projections of inflation, unemployment, and real GDP growth, it would be appropriate to delay raising rates from zero until 2023.  In the dot-plots of the FOMC members’ estimates, seven members estimated that it would be appropriate to raise rates by year-end 2022, while 11 thought it would be appropriate to delay a rate increase until 2023.  We believe at least two members will switch their estimates such that the median FOMC estimate will indicate that raising rates in 2022 would be appropriate.  

 

 

Mickey Levy, mickey.levy@berenberg-us.com

 

 

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