Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s “substantial further progress” criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum-employment goal. Various participants commented that economic and financial conditions would likely warrant a reduction in coming months.
The Minutes of the the FOMC Meeting held on July 27-28, 2021 revealed an emerging consensus among the FOMC participants about the potential for tapering off the US Federal Reserve’s COVID crisis related assets purchase policy as early as this year. This change of tone among the Fed’s policymakers has been motivated by the progress made toward the realisation of the guidance set in December 2020. More specifically, most participants have judged that the guidance toward an inflation moderately above 2 percent – consistent with the Fed’s new Average Inflation Targeting framework – has already been achieved while the “substantial further progress” toward the maximum employment objective has not been achieved yet but that the economy was steadily moving in that direction, despite the threat posed by the Delta variant and its impact in delaying a full reopening of the US economy.
The released Minutes of the Federal Open Market Committee held on July 27-28, 2021 triggered a temporary equity market sell-off. This did not prevent the equity markets to move back into a risk-on mode and to regain some of their losses. The S&P and Nasdaq are still up by more than 15 percent on a year-to-date basis (cf. chart below). This contrasts with the broader Russell 2000 which is still about 10 percent off its peak, signalling the heavy bias exercised by a few outsized companies on the overall direction of the S&P 500. However, the most interesting reaction came from the bond markets. Indeed, following the releases of the Minutes, the yield curve exhibited diverging movements at different maturities with the yield on 2-years Treasuries increasing by 20 basis points over three days while the yield on the 10 years US treasuries remained barely unchanged.
The Tapering risk balance
For all the uncertainty about the actual trajectory of US monetary policy in the upcoming months, the Fed’s tapering momentum is building up and the Minutes of the July meeting show that the Fed’s policymakers’ overwhelming priority put on fighting unemployment in the immediate aftermath of the COVID crisis is gradually being rebalanced with more focus on inflation. The COVID-19 cycle is a very peculiar one. This relates to a set of unusual patterns that appeared in the wake of the pandemic and the reaction to it. Something we have already discussed and dubbed the “COVID conundrum” in a previous post.
Let us look at the balance of risks. Despite the supply side bottlenecks that appeared as US and global demand for goods boomed – especially for durable goods -, the recent surge of inflation is considered by most FOMC participants and by the broader economist community mostly as a temporary phenomenon and not as broad-based price surge which has the ability to significantly support itself going forward. It is not unusual to observe inflation peaking when the business cycle is already well advanced in its expansion stage. The challenge for the Fed now is to manage a business cycle that has no historical equivalent. The Fed has to deal with the consequences of an ultra-expansive monetary and fiscal policy mix that was originally intended to support households and businesses as they were grappling with the crisis but which was prolonged far beyond the COVID recession itself, which lasted only two months, as per the NBER.
On the other hand, the downturn in US 30 years yields signals the increasing fear of returning to a post-GFC secular stagnation scenario if the Fed’s tapering hand is too heavy and if it reacts before the labour market has completely recovered from the effects pandemic. An additional difficulty here, outlined by some participants to the July FOMC meeting is the changing nature of the labour market. These structural changes could have permanently lowered the participation rate and hence raised the NAIRU – or Non Accelerating Inflation Rate of Unemployment.
Solving this equation will require careful communication as the Fed will have to achieve a decoupling in market expectations between the impact of tapering its crisis-related asset purchases and the more traditional interest rate channel of monetary policy, with more onus put on the latter.