Federal Reserve Chairman Jerome Powell listens during a Senate Banking Committee hearing on “The Quarterly CARES Act Report to Congress” on Capitol Hill in Washington, United States, on Dec. 1, 2020.
Susan Walsh | Reuters
The Federal Reserve is in the early stages of a campaign to prepare the markets to reduce their monthly purchases of $ 120 billion to stimulate the economy.
Comments from Fed officials over the past few weeks suggest that tapering is likely to be discussed at this upcoming June meeting, and the Fed may be on the right track, later this year or early next year, with asset deleveraging to start.
At least five Fed officials have spoken publicly in the past few weeks about the likelihood of these discussions, including Patrick Harker, President of the Federal Reserve Bank of Philadelphia, Robert Kaplan of Dallas, Fed Vice Chairman of Banking Supervision Randal Quarles, and Cleveland Fed President Loretta Mester, whose comments came to CNBC after the job report.
“As the economy continues to improve and we see this in the data and we get closer to our goals … we will have discussions about our general attitudes, including our asset purchase programs and including our interest rates,” Mester said Friday.
While the discussion may take place, an announcement of a decision to actually reduce would be made a few months later, perhaps in late summer or early fall. That announcement would then delay the start of the asset runoff even further, perhaps until the end of the year or early next year. Since the Fed is going to curb its purchases – that is, reduce the amount it buys each month by a certain amount – the Fed would buy billions of dollars in assets on that schedule well into 2022, albeit forever slower pace.
It all depends on how the economy recovers from the pandemic. The recent pace of employment growth averaging 541,000 over the past three months and the recent decline in the unemployment rate seem more or less in line with Fed expectations. Most Fed officials continue to believe that the recent surge in inflation will prove temporary, so even large monthly gains will not accelerate the plan, at least temporarily.
The decision to reduce, while based on economic data, is eventually converted to calendar data by Fed officials, although, as the Fed has done in the past, it is still tied to the data.
Behind the icy pace of the reduction in bond purchases is a deliberate attempt to avoid what is known as a taper tantrum, a sharp spike in bond yields in 2013 after Fed chairman Ben Bernanke suggested that bond purchases could be halted.
One opinion within the Fed is that the taper tantrum occurred because the market consciousness failed to properly separate the timelines for raising interest rates from those for reducing asset purchases. This time the Fed is creating a long runway for tapering and making it clear that rate hikes will only come after this process. It has also set a higher standard for economic improvements required for rate hikes than for asset purchases being reduced.
Quarles made this separation clear late last month, saying, “It will be important for the FOMC to discuss our plans to adjust the pace of asset purchases at upcoming meetings.” But he added, “In contrast, the time to discuss a change in the federal funds rate is still a long way off.”
At the moment, the bond markets appear to be giving the Fed leeway to follow a gradual schedule. The yield on 10-year notes has been around 1.60 percent for nearly four months, and the interest rate on 2-year notes has moved 15 basis points. Fed Funds futures do not fully price a 25 basis point rate hike from the Fed through early 2023.
Fed officials expected volatility related to any announcement that it would cut asset purchases. And it is clear that this could increase returns. It is possible that markets will become more aggressive in pricing rate hikes. The measure of success in the Fed’s current efforts will be if it can reduce bond purchases but see only minor changes in expectations for rate hikes.
The main risk now is that in order to avoid a taper tantrum, the Fed may hold on to its loose monetary policy for too long, making inflation a permanent, not just temporary, problem.