The pressure is on for Powell and the Federal Reserve to manage the exit from ultra-easy policies

Federal Reserve Chairman Jerome Powell says during a hearing for the U.S. House Oversight and Reform Selection Subcommittee on the coronavirus crisis Jan.

Graeme Jennings | Swimming pool | Reuters

For the Federal Reserve, implementing the simplest monetary policy in the institution’s history was difficult enough. Getting out of the car won’t be a pleasure either.

That is what the central bank has ahead of it on its way.

Investors will learn more on Friday about what Fed chairman Jerome Powell thinks of the economy, and they also expect to receive at least a few more pointers on how to steer the central bank’s exit from bailout efforts becomes the Covid-19 pandemic. He will be speaking in connection with the Fed’s annual Jackson Hole conference, which will also take place virtually this year.

First, the Fed is pulling back on money printing – about $ 120 billion in bonds it buys every month to stimulate demand and lower long-term interest rates.

After that the road gets rougher.

At some point, the Fed will attempt to raise short-term interest rates from the near-zero anchor it has been sitting on since March 2020. The normalization in interest rates did not do well for the Fed on its last attempt to do so in 2015-18 as it had to stop mid-cycle amid a collapsing economy.

The markets could therefore be excused for being at least a little nervous this time around. Not only does the Fed need to reverse its most aggressive easing policy ever, it needs to be precise, and hopes it will not break anything in the process.

“Any change in the Fed’s monetary policy is important,” said Priya Misra, TD Securities global head of rate strategy. “But I think it’s especially significant today because we know that growth is slowing and the Fed is trying to get out.”

In fact, the economy is still in a strong recovery from the depths of the pandemic that led to the steepest but shortest recession in US history. But the recovery appears to be stalling, if not declining. The Citi Economic Surprise Index, which measures actual data versus Wall Street estimates, hit a record high in mid-July but has now fallen to levels last seen in June 2020 in the early days of Covid-19 .

Fed officials themselves expect noticeably slower growth in the coming years at a time when both monetary and fiscal policies are tightening. That begs further questions as to whether Powell and his cohorts are getting the exit right.

Concerns in the market

“Are they going out in the right place? Are they getting out at the right time at the right size? With the economy slowing, we have questions about both of them,” Misra said. “The market is pricing in a political mistake.”

What Misra means by a political mistake is that current pricing in Fed fund futures, the market that trades for Fed interest rate movements, is suggesting that the Fed may only lower its rate to maybe 1.25% a few times. can raise, but then will have to stop as growth stalls.

Fed officials are frightened by the low interest rates because they leave little room for maneuver in times of crisis to loosen up policy. This was roughly the level of the key interest rate at the beginning of the pandemic crisis, which fell well below the target range of 2.25% -2.5% in which the Fed ended its last rate hike cycle in December 2018.

The calculation of how to handle all of this will fall on Powell from a communicative point of view and the other members of the Federal Open Market Committee in terms of the actual mechanics.

“Tapering is important because it is not only a very good measure of the Fed’s credibility, but also in terms of communicating how good the strategy is and how transparent it is,” said Deepak Puri, Chief Investment Officer for America at Deutsche Bank wealth management. “In 2013, the Fed made mistakes communicating about tapering.”

This 2013 episode – the so-called Taper Tantrum as it is known today – is the only template the market has for how the Fed could go about it.

Misra, the strategist at TD Securities, pointed out that the Fed is already showing that it has learned from the previous episode by now throttling the market. The 2013 proclamation by then Fed chairman Ben Bernanke was seen as abrupt, causing interest rates to skyrocket and stocks to decline for several months before these trends reversed.

“They do a good job in the sense that they are really trying not to surprise the markets. That avoids a mistake they made in 2013. That’s positive, ”said Shawn Snyder, Head of Investment Strategy at Citi US Consumer Wealth Management. “You are in a somewhat difficult position because the Delta variant acts as a wildcard.”

Depending on the Fed

The Fed and the markets were on the hip for a long time, but especially during the time of quantitative easing and zero interest rates that started buying bonds up in 2008.

During the first taper, the market eventually made up for losses even after the taper began and during the rate hike cycle – until late 2018, when a series of Powell communication errors rocked investors.

Fed balance sheet, stock market rise

As the Federal Reserve built its balance sheet, the S&P 500 index rebounded

from the Covid crash at record level

Federal Reserve total assets

Note: The shaded area represents the US recession. The Fed’s balance sheet data are unadjusted.

Source: Board of Governors of the Federal Reserve System, through the Federal Reserve Bank of St. Louis

(Assets), FactSet (S&P 500). Data as of August 18, 2021.

Fed balance sheet, stocks rise

When the Federal Reserve got its equilibrium

Leaf, the S&P 500 index rebounded

from the Covid crash at record level

Federal Reserve total assets

Note: The shaded area represents the US recession. fed

Balance sheet data are unadjusted.

Source: Federal Reserve Board of Governors

System, through the Federal Reserve Bank of St. Louis

(Assets), FactSet (S&P 500). Data from 08/18/21.

Fed balance sheet, stock market rise

As the Federal Reserve was building its balance sheet, the S&P became 500 index

recovered from the Covid crash and reached record values

Federal Reserve total assets

Note: The shaded area represents the US recession. The Fed’s balance sheet data are unadjusted.

Source: Board of Governors of the Federal Reserve System, via the Federal Reserve

Bank of St. Louis (Assets), FactSet (S&P 500). Data as of August 18, 2021.

In terms of the economy, Fed officials have put less emphasis on their policies and put more emphasis on tax aid and the virus’ path.

The Covid strain casts doubt on where the growth is going. But several regional Fed presidents speaking to CNBC this week said the virus appears to have little impact on growth and is not weighing on their economic forecasts for the time being.

“Consumers and businesses are becoming more adaptable and resilient, and I think people expect that [the virus] will go in seizures, “said Robert Kaplan, president of the Dallas Fed, one of those who advocate a slow pace of policy adjustments.

The informal market consensus is that the Fed will start tightening before the end of the year and complete the process in eight to ten months. After that, an assessment is made of where things are before prices are changed.

Land mines for Powell

To make matters worse for Powell are some delicate political dynamics both inside and outside the Fed.

The rising Hawkish tendency of regional presidents like Kaplan and James Bullard at the St. Louis Fed clashes with more reluctant members like Governor Lael Brainard and San Francisco Fed President Mary Daly.

In addition, Powell is up for renomination in February, as are several other Fed officials, and President Joe Biden has not yet announced his preferences. Powell already knows what it is like to have to rely on keeping interest rates low after his experience with former President Donald Trump, but he’ll still have to herd cats to some extent to hold a Fed consensus together, if economic and pandemic conditions change.

A picture of US President Joe Biden will be broadcast on a screen after his address to the nation on the situation in Afghanistan while traders are on the trading floor of the New York Stock Exchange (NYSE) in Manhattan, New York City, USA, 17, 2021 .

Andrew Kelly | Reuters

“The concern of both the Fed and the economy is the danger of exerting political pressure to achieve the desired outcomes across the political spectrum and thereby undermining the independence of the Fed,” said Charles Plosser, former Philadelphia Fed President. in a television interview with CNBC. “Powell is in a tricky place.”

For his part, Powell used his Jackson Hole 2020 speech to outline a dramatic change in policy regarding the Fed’s view of inflation. The new framework reflects a desire to achieve full and inclusive employment, even if it means high inflation, and policy has been blamed for price hikes this year in some quarters.

“We are at a time when monetary and fiscal policy is at the most stimulating level that we have seen in 75 years,” said Plosser. “You have to ask yourself what role politics is playing in making this inflation more persistent than it would otherwise prove to be.”

Powell’s speech on Friday is unlikely to bring such big breakthroughs in the Fed approach, instead focusing on current and future expected conditions with a little hint of how he and his policy makers will try to manage it all.

But it will likely set the stage for the central bank to return to normal so the pressures remain.

“The real question for me is what happens next year,” said Snyder, the Citi strategist. “Are we in the process of tempering the economy and inflation that will make it harder for the Fed to raise interest rates? . “

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