Stephen Miller
Powell signals Fed to begin tapering this year…
In a much anticipated speech on Friday, Fed Chair Powell gave his strongest signal yet that the Fed will begin to taper its bond purchases this year, declaring that the U.S. economy has met the central bank’s test of “substantial further progress” toward its inflation goal and that it has made “clear progress” on the labour-market front. While Powell stopped short of nominating when the Fed might set out a tapering roadmap, it seems that should the August employment report (to be released on September 3) come in close to the current consensus of an increase of circa 750k, such an announcement could come as early the September 21-22 meeting, although that remains very much open to conjecture.
No taper tantrum…
Markets took the announcement with equanimity as bond yields retreated somewhat from earlier highs and equity markets eked out impressive gains to close at an all-time high.
So much for a dreaded ‘taper tantrum’ such as that when then Fed Chairman Bernanke canvassed a similar paring of bond purchases back in May 2013.
The difference this time around might be attributed to three key factors:
- First, such a move had been well-telegraphed by the Fed Chairman in contrast to the “drive-by” announcement from then Fed Chair Bernanke back in May 2013. It also helped that Fed hawks had softened up the markets prior to Powell’s address by indicating their preference for an early start to tapering.
- Second, Powell was careful to give the Fed the requisite flexibility to tweak both the timing and nature of any tapering saying that the Fed “will be carefully assessing incoming data and the evolving risks”, particularly given uncertainties attaching to the spread of the COVID delta variant.
- Third, Powell was at pains to emphasise that any tapering should not be interpreted as a sign that increases in the policy rate might soon follow, emphasising that “the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate lift-off, for which we have articulated a different and substantially more stringent test.”
Fed’s preferred inflation measure remains elevated…Fed Chair maintains inflation is transitory…
Powell’s comments came just a short while after the Fed’s preferred measure of inflation showed an increase of 3.6% over the year to July, the highest since May 1991. On a 3-month annualised basis, that translates into an increase of 6.2% which would be the highest since September 1982. At its March meeting, the FOMC had a median core PCE projection of 2.2% for 2021. That was revised to 3.0% at the June meeting but the July result means that inflation in the first seven months of 2021 is already at 2.8% which almost inevitably means that the Fed will have to revise again its forecast at the September meeting.
Powell maintained at Jackson Hole that inflation was essentially of a “transitory” nature driven largely by temporary supply bottlenecks. Moreover, Powell asserted that structural factors such as aging populations in the United States and elsewhere, along with globalization and advancements in technology, are pushing down on prices globally and that these forces will reassert themselves quickly as the impact of the pandemic passes. That is a sentiment that seems to find acceptance within the bond market given the apparent disconnect with the current inflation pulse and bond yields. Obviously some of that is explained by the Fed’s bond purchases but even allowing for the impact of such purchases, a disconnect is apparent. Powell – implicitly at least – seems to think that disconnect is resolved by inflation drifting lower in 2022 and beyond.
Some commentators question Powell’s sanguine inflation view…
However, that sanguine view on inflation is under question from a number of economists, most notably Obama-era Treasury Secretary Larry Summers, who on Friday maintained that Powell’s remarks on inflation amounted to a “serene” depiction of inflation that is potentially a fundamental misreading of the upside risks. For good measure, Summers added that that it’s “bizarre” for the Fed to still be pumping liquidity into markets with bond buying, which to his mind is producing “toxic” side effects.
Others question whether inflation simply reflects temporary supply bottlenecks.
They point not only to historically high levels of monetary accommodation but also to the notion that fiscal stimulus appears to have been a multiple of any measure of the output gap. Household savings are also still high (although off their peak) and buoyant equity and real estate markets are a strong tailwind to demand.
The Powell assertion that structural forces will continue to suppress inflation is also contestable. Former Bank of England Monetary Policy Committee member and former London School Of Economics Professor, Charles Goodhart, maintains that there are structural currents driving inflation arising from the reversal of the two great structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply and baby boomer workforce participation. Add to that a backlash against globalisation of markets, re-regulation as well as ongoing supply chain constraints, it may well be that structural forces are no longer as powerful in keeping inflation dormant perhaps offsetting structural inflation suppressors such as technology and demographics.
Still others point to inflation sustained by its own momentum: “the inflation genie gets out of the bottle” and once that occurs, it is a difficult process getting the genie back inside the bottle. That is precisely what happened with the oil price shocks of the ‘70s when policy generally “accommodated” the increase in oil prices. If supply shocks manifest themselves in higher inflation expectations then that can have an impact on purchasing behaviour, putting increased pressure on limited supply.
A taper tantrum may have been avoided for a time but inflation frustration may still yet emerge.
By Steve Miller, investment strategist