Still tentative Fed inches closer to tapering its asset purchases

Still tentative Fed inches closer to tapering its asset purchases

The Federal Reserve has decided at its July 27-28 FOMC meeting to keep monetary policy unchanged but signaled that it is inching towardannouncing that it will eventually taper its asset purchases. The Fed stated that the economy has continued to improve but it has not fully recovered, and that it would continue its current pace of purchases ($80 billion per month of Treasuries and $40 billion per month of MBS) until “substantial further progress had been made”. The Fed’s Policy Statement stuck to its ongoing assessment that inflation “largely reflects transitory factors”. Despite differences of opinion among FOMC members, there were no official dissents.

The Fed’s new strategic framework prioritizes maximum inclusive employment and favors inflation overshooting its longer-run 2% average inflation target, but it did not include any numeric guidelines for either mandate. The Fed’s decision to maintain its current monetary policies seems to be stretching its interpretation of this framework, and the Fed is clearly understating the risks.

Employment. Although employment has recovered significantly, it remains approximately seven million below pre-pandemic levels, so Fed Chair Powell says improvement has “a ways to go”. Of note, in its June Summary of Economic Projections (SEPs), based on the FOMC’s median assumption that it will keep rates at zero through 2022 and hike rates twice (25 basis points each) by year-end 2023, the Fed forecast that economic growth would remain strong (3.3% real GDP growth in 2022 and 2.4% in 2023) and the unemployment rate would fall back down to 3.5%, decidedly below the FOMC’s estimate of “full employment” (the Fed’s SEPs do not provide any information on its balance sheet). There is widespread anecdotal evidence that labor supply shortages are constraining employment gains, and wages have accelerated. The Fed needs to consider how sustaining its asset purchases are overcoming these supply constraints. Would a gradual tapering of assets harm labor markets? Highly unlikely, in our view.

Inflation. Inflation has risen significantly higher than the Fed has been predicting, and while some of it seems to be attributable to temporary factors, more persistent inflation pressures seem to be mounting. As recently as December 2020, the FOMC forecast that inflation in 2021 would be 1.8%. It raised its forecast to 2.4% in March and to 3.4% in June, and the recent data suggest actual inflation will rise higher. If actual real GDP growth and the unemployment rate are close to the Fed’s forecasts, the risks of rising inflation are high, even if current factors that are temporarily accentuating inflation dissipate. Before the pandemic, Powell stated clearly that forecasting inflation was very difficult, and that the Fed’s forecasts of inflation had been unreliable. Such an honest statement was refreshing and the Fed should take it to heart: amid significant uncertainty, the Fed would be wise to acknowledge upside risks to the inflation outlook and begin to normalize policies.

The Fed’s current policies were put into place in March 2020 as an emergency response to the unfolding pandemic severe dysfunction in the Treasury market and among primary dealers in Treasury securities. Continuing those policies are clearly boosting financial markets but extending them is not necessary to sustain the economic expansion or further gains in employment. They are generating significant stresses in short-term funding markets, and most importantly raise inflation risks. The primary rationale why the Fed is continuing such polices is fear that tapering assets may jar financial markets. With bond yields so far below inflation and inflationary expectations, we think the Fed should get over such concerns.

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

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