– Pace of Tapering Adjustable; Funds Rate Liftoff Timing Uncertain
By Steven K. Beckner
(MaceNews) – The fateful moment is nearly upon us – when the Federal Reserve at last starts trimming the aggressive bond buying it’s been doing to support a pandemic-weakened but rapidly recovering economy.
Having prepared financial markets as much as it possibly can, the Fed’s policy-making Federal Open Market Committee will almost certainly make a “tapering” announcement Nov. 3. Chairman Jerome Powell seems to have succeeded in crafting a strong consensus, indeed near unanimity, in favor of a November start. Markets are likely to get the outcome they now expect – monthly cuts in Fed purchases of $10 billion for Treasuries, and $5 billion for mortgage-backeds, to start soon.
At the Sept. 21-22 FOMC meeting, minutes show that participants were satisfied that the December 2020 standard of “substantial further progress” had been met with regard to the 2% average inflation objective. And a majority thought the “maximum employment” progress standard either “had been met” or “may soon be reached.”
So, while the FOMC shrank from announcing tapering on Sept. 22, the minutes say, “participants generally assessed that, provided that the economic recovery remained broadly on track, a gradual tapering process that concluded around the middle of next year would likely be appropriate.”
The goal all along has been to avoid repeating the infamous 2013 “taper tantrum.” This time, financial markets have become accustomed, in a fairly orderly manner, to anticipating reduced bond buying, as shown by the steady climb in the 10-year Treasury note yield from an Aug. 4 low of 1.13% to 2.66% at this writing.
It’s doubtful Powell will want to emulate the Grand Old Duke of York, who as the nursery rhyme relates, marched his troops “up to the top of the hill, and he marched them down again.” Better to go ahead and fulfill expectations.
Although the September non-farm payroll gain was much less than expected for the second straight month (194,000 vs. 500,000), that is unlikely to cause the FOMC to defer tapering. Both Powell and New York Federal Reserve Bank President John Williams have said they view “progress” toward “maximum employment” as “cumulative.”
After the September FOMC meeting, Powell told reporters, “It wouldn’t take a knockout, great, super strong (September) employment report.” He said it would just take “a reasonably good employment report for me to feel like that test is met.”
Since the upcoming meeting is taking place so early in the month, the first actual reductions in asset purchases may well come before the end of November. The September minutes say that “if a decision to begin tapering purchases occurred at the next meeting, the process of tapering could commence with the monthly purchase calendars beginning in either mid-November or mid-December.”
It’s been a long road to this point.
When government-ordered shutdowns to combat the coronavirus pitched a vibrant economy into sharp recession last March, the Fed responded not only by slashing the federal funds rate to near zero, but also by launching unlimited “quantitative easing, not to mention 11 special lending facilities.
Heavily front-loading the asset purchases, the Fed initially bought as much as $100 billion per day before settling into the current $120 billion per month pace in June 2020. Last December, the FOMC announced it would keep buying $80 billion of Treasury securities and $40 billion of agency mortgage-backed securities per month “until substantial further progress has been made toward its maximum employment and price stability goals.”
From March to December 2020, the Fed’s assets increased by $3 trillion.
This expansion in the Fed’s bond portfolio was not accompanied by a commensurate increase in Fed liabilities in the form of bank reserves, because at the same time the U.S. Treasury’s General Account (TGA) with the Fed rose dramatically. Growth in the TGA “limited reserve growth associated with the balance sheet expansion” last year, as New York Fed Executive Vice President Lorie Logan recently observed.
This year has been a different story, with the action shifting to an astonishing expansion in use of the Fed’s overnight reverse repurchase facility, as yield-seeking financial firms fled to the Fed to park cash. Recently, reductions in the TGA and Treasury bill supply have accelerated, and the ON RRP facility has exceeded $1.2 trillion consistently since mid-September.
That’s all right, says Logan. Given FOMC’s commitment to using “its full range of tools—including large-scale asset purchases … extended periods of elevated ON RRP usage may be a relatively regular feature of the ample reserves framework. This isn’t a challenge for monetary policy implementation; it’s the framework working as designed.”
While there seems to be a strong consensus for getting on with tapering, the pace of tapering might be another matter, depending on how economic and financial conditions evolve.
At the Sept. 21-22 meeting, the FOMC was treated to an “illustrative path” for tapering presented by the Fed Board staff, which proposed “a gradual reduction in the pace of net asset purchases that, if begun later this year, would lead the Federal Reserve to end purchases around the middle of next year,” according to the minutes.
Powell gave reporters a similar timeline in his post-FOMC news conferences.
The staff proposed reducing Treasury purchases by $10 billion and MBS purchases by $5 billion per month – precisely the amounts this reporter estimated the Fed would be likely to do before the last FOMC meeting.
The staff presentation seems to have been well-received. “Participants generally commented that the illustrative path provided a straightforward and appropriate template that policy-makers might follow …,” say the minutes.
But there is not unanimity on the tapering pace. The minutes say, “several participants indicated that they preferred to proceed with a more rapid moderation of purchases than described in the illustrative examples.”
St. Louis Federal Reserve Bank President James Bullard, who will be an FOMC voter next year, favors completing asset purchases by the end of the first quarter to give policy-makers flexibility to raise the federal funds rates sooner if needed to keep inflation in check (since the FOMC has said “liftoff” for the funds rate will only come after tapering is finished.)
One thing is certain: the pace of tapering is subject to change. At their last meeting, officials commented the FOMC “could adjust the pace of the moderation of its purchases if economic developments were to differ substantially from what they expected.”
Fed Governor Christopher Waller elaborated on the need for flexibility on Oct. 19. “If economic conditions and the outlook were to deteriorate significantly, we could slow or pause this tapering,” said the former Bullard advisor. “And if the economy were to strengthen more than expected, the plan to rapidly end purchases would provide policy space in 2022 to act sooner than now anticipated to begin raising the target range for the federal funds rate.”
It almost goes without saying that the FOMC will surely keep the funds rate in the zero to 25 basis point target range. But, if there is dissension about the pace of tapering, there is even less agreement on the timing and pace of liftoff.
The FOMC won’t be compiling another set of funds rate projections – the “dot plot” –until the Dec. 1-15 meeting. But at the last meeting, FOMC participants were split down the middle, with half the 18 projecting at least one rate hike next year (far more than earlier in the year) and the other 9 foreseeing no rate hikes until 2023.
Some Fed watchers seem to think liftoff will quickly follow the end of tapering. Not necessarily. Waller for one said, “Based on my outlook for the economy … I do not expect liftoff to occur soon after tapering is completed.”
“The two policy actions are distinct,” he continued. I believe the pace of continued improvement in the labor market will be gradual, and I expect inflation will moderate, which means liftoff is still some time off.”
Voting Atlanta Fed President Raphael Bostic said he was ready to taper in an Oct. 12 webinar, but saw rate hikes as “more than a year off.” He favored a “lower for longer” approach to interest rates to maximize employment, but that could change if supply-related wage-price pressures cause inflation expectations to become “unanchored” and in turn disrupt the economy and employment.
Clearly, inflation is a theme that will dominate FOMC deliberations, as it has increasingly dominated public discussions. After many months of whistling past the graveyard with the incantation that elevated inflation is “transitory,” Fed officials have begun to concede the real danger that inflation will persist above the 2% target and not just “moderately” for “some time,” as the FOMC policy statement would have it.
The latest inflation data are not pretty. The 0.4% September rise in the consumer price index left prices up 5.4% from a year ago, 6.5% on an annualized basement this year – fastest pace in 13 years. Even “core” inflation is running at 4%.
The Fed’s latest “beige book” survey of economic conditions in the 12 Fed districts, prepared for review at the November FOMC meeting, provides anecdotal confirmation: “Most Districts reported significantly elevated prices, fueled by rising demand for goods and raw materials.”
“Reports of input cost increases were widespread across industry sectors, driven by product scarcity resulting from supply chain bottlenecks,” the beige book continued. “Price pressures also arose from increased transportation and labor constraints as well as commodity shortages. Prices of steel, electronic components, and freight costs rose markedly this period. Many firms raised selling prices indicating a greater ability to pass along cost increases to customers amid strong demand. Expectations for future price growth varied with some expecting price to remain high or increase further while others expected prices to moderate over the next 12 months.”
Wages are rising amid scarcities of willing workers: “The majority of Districts reported robust wage growth. Firms reported increasing starting wages to attract talent and increasing wages for existing workers to retain them. Many also offered signing and retention bonuses, flexible work schedules, or increased vacation time to incentivize workers to remain in their positions.“
The National Association for Business Economics’ latest survey shows many members saying “the biggest downside risk to their company’s outlook is increased cost pressures.”
Not surprisingly, we are hearing less and less talk of “transitory” inflation and more expressions of concern about lasting acceleration of wage-price pressures.
At the last FOMC meeting, “participants observed that the inflation rate was elevated, and they expected that it would likely remain so in coming months before moderating,” say the minutes, which note participants had “marked up their inflation projections, as they assessed that supply constraints in product and labor markets were larger and likely to be longer lasting than previously anticipated.”
The minutes say, “some participants expressed concerns that elevated rates of inflation could feed through into longer-term inflation expectations of households and businesses or saw recent inflation data as suggestive of broader inflation pressures.”
Concerns were also expressed that “the possibility” of a wage-price spiral “merited close monitoring.”
Since September, policy-makers have intensified their inflation warnings. For instance,
while saying it’s too soon to say the economy has entered a “wage-price spiral,” Bostic said price stability “could be on the line in coming months.”
Nor are inflation worries confined to Fed presidents. Board members have also been second-guessing Powell’s “transitory” mantra. Take Randall Quarles, who on Oct. 20 said, “the question is not only whether inflation will fall in the coming months, but also how far it will fall and if it will fall soon enough to avoid spurring a concerning rise in longer-term inflation expectations.”
Quarles, until recently Vice Chairman for Supervision. was inclined to agree that “inflation likely will decline considerably next year from its currently very elevated rate,” but said “I see significant upside risks to my current inflation outlook.”
“Supply constraints in production and distribution already have become more widespread and have lasted longer than most forecasters anticipated…,” he continued. “(L)abor supply constraints are making it difficult for businesses to keep up with demand. This dynamic will continue to support robust wage growth, putting further upward pressure on prices.”
“Moreover, there is evidence in the past couple of months that a broader range of prices are beginning to increase at moderate rates, and I am closely watching those developments,” Quarles added.
“The fundamental dilemma that we face at the Fed right now is this: Demand, augmented by unprecedented fiscal stimulus, has been outstripping a temporarily disrupted supply, leading to high inflation …,” he went on.
Quarles warned, “‘transitory’ does not necessarily mean ‘short lived.’ Indeed, we are discovering that it’s going to take more time than we had thought for supply to return to normal, and with demand already high during that time, I am monitoring the extent to which it could be further boosted by the additional fiscal programs currently under discussion.”
“If those dynamics should lead this ‘transitory’ inflation to continue too long, it could affect the planning of households and businesses and unanchor their inflation expectations,” he cautioned. “This could spark a wage-price spiral that would not settle down even when the logistical bottlenecks and supply chain kinks have eased …..”
Two days after Quarles spoke, Governor Michelle Bowman expressed hope that “as the various supply bottlenecks we are currently seeing are gradually resolved, we should see monthly inflation readings step down further from the high rates we have observed this year.” However, she said she “still see(s) a material risk that supply-related pricing pressures could last longer than expected.”
Bowman, known for her community banking expertise, said “another source of inflation risk comes from the lower labor force participation, which … has led some firms to offer inducements to bring potential workers back .… Wage increases and these additional employee investments are increasing firms’ costs, potentially adding to inflationary pressures.”
“If elevated inflation readings continue into and through the next year, we may begin to see an imprint on longer-run inflation expectations,” she added.
Waller is holding on to hope that “the escalation of inflation will be transitory and that inflation will move back toward our 2 percent target next year,” but said, “I am still greatly concerned about the upside risk that elevated inflation will not prove temporary.”
Even Powell began changing his tune on inflation in advance of the FOMC meeting. “Supply-side constraints have gotten worse,” he said at a virtual conference on Oct. 22. “The risks are clearly now to longer and more-persistent bottlenecks, and thus to higher inflation.”
Waller emphasized the need to contain inflation expectations: “I believe the next few months will be crucial to understanding whether elevated rates of inflation last and if that will trigger a lasting effect on the U.S. economy. We will know more as time goes on about whether inflation in the prices of those goods and services will level off or even fall, as lumber prices have, and how other prices will evolve. But, importantly, we will also know whether this period of higher inflation has started to affect expectations of future inflation……
“If inflation expectations become unanchored, the credibility of our inflation target is at risk, and we likely would need to take action to re-anchor expectations at our 2% target,” he said, noting that “survey measures have shown a dramatic increase in inflation expectations over the past few months.”
The New York Fed’s survey shows short- and medium-term inflation expectations at 5.3% and 4.2%, respectively – results which Waller called “eye opening and a genuine cause for concern should households embed these expectations in wage demands.”
Tamer market-based measures of inflation expectations only partially comfort officials.
So far, mounting concerns about inflation are not causing policy-makers to abandon their emergency monetary easing, but tapering has clearly been accelerated by inflation trends. It’s also noteworthy that the number of FOMC participants projecting a 2022 rate hike has grown from one in December 2020 to nine in September. If new rate projections were to be published on Dec. 3, it’s possible the number would be even higher.
As time goes on, inflation concerns could accelerate monetary tightening.
Quarles said, “we haven’t yet met the more stringent tests for liftoff that we have laid out in forward guidance about the federal funds rate.” And he said, “constraining demand now, to bring it into line with a transiently interrupted supply, would be premature.”
“Given the lags with which monetary policy acts, we could easily find that demand is damping just as supply is increasing, leading us to undershoot our inflation target—and, in the worst case, we could depress the incentives for supply to return, leading to an extended period of sluggish activity and unnecessarily low employment,” he continued.
However, Quarles said the Fed would have to use its “monetary policy tools” “if the broadly held expectation that inflation will recede next year turns out to be wrong or if inflation expectations show signs of becoming unanchored to the upside .…”
Looking past the start of tapering, one question that arises is how the Fed will respond if inflation remains elevated while the maximum employment goal remains short of attainment due to labor supply impediments.
If inflation and inflation expectations were rising while labor supply issues were perpetuating unemployment and suppressing labor force participation, the Fed would unquestionably face a dilemma. How it would respond would depend on how bad the inflation picture really gets.
This is the “balance” issue addressed in the FOMC’s revised Statement on Longer-Run Goals and Monetary Policy Strategy: “The Committee’s employment and inflation objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it takes into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.”
In theory, the Fed should react by dealing with inflation. Knowing monetary policy cannot address structural labor market issues and that keeping its foot on the monetary accelerator would only worsen inflation without solving the labor market issues, the appropriate response would be to lean against inflation. And Powell has vowed the Fed will “use its tools” to confront persistent “troubling” inflation..
Now, whether the Fed will actually do that is another matter. Powell’s position has been that inflation pressures are “transitory” and that labor market issues will also take time to work themselves out.
To some extent there are questions of “time inconsistency.” The Fed doesn’t know whether inflation pressures will outlast the labor market problems or vice versa.
Over the next year, if elevated inflation persists, officials have indicated they would tilt toward quicker tapering rather than earlier rate hikes. Ultimately, though, if Powell and Co. mean what they say, they would have to resort to rate hikes.
Historically though, the Fed has been slow in responding, as it was in the 1970s.