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What does a faster taper mean?
A sooner end to quantitative easing need not get in the way of the recovery—unless the Fed lets it
Note: any and all opinions are entirely my own and do not necessarily reflect those of the Cleveland Fed, the FOMC, or any other person or entity within the Federal Reserve System. I am speaking exclusively for myself in this post (as well as in all other posts, comments, and other related materials). No content whatsoever should be seen to represent the views of the Federal Reserve System.
On Wednesday, the Federal Reserve announced that they would speed up the tapering process, with purchases now scheduled to end in March. What does this mean about the near future? In this post (which is admittedly a bit wordy!), I’ll go through why the taper speed matters, what it means about the future, and tie it back into the Fed’s Flexible Average Inflation Targeting regime.
Why it matters
In my last post, I wrote about the Fed and the yield curve (and other assets) while making the case that the Fed determines not just short term interest rates, but long term interest rates as well. They do this by setting expectations for the future path of short term interest rates, the interest rates the Fed explicitly sets. When the Fed leads markets to expect tighter policy in the future, that is itself tighter policy now—even if nothing changes today.
Quantitative easing—a phrase I generally try not to use, since the Fed favors “large scale asset purchases”, the more accurate term—works largely through the expectations channel. Since the Fed has thoroughly convinced markets that it will not raise interest rates at least until it concludes its asset purchases, we know a real lot about the path of short term interest rates as long as asset purchases are still ongoing.
What Wednesday’s announcement changed was the time frame in which we know interest rates will still be at zero. The old tapering scheme from November’s FOMC meeting would’ve concluded asset purchases in June; the new scheme is set to finish them in March. Translating this to interest rates, we went from having an extremely high certainty of interest rates being at zero until June to only having that certainty until March. We went from knowing that the Fed would walk away from March and May’s FOMC meetings leaving rates unchanged to the Fed possibly only having one hike-free statement left.
What it means
There are a few perspectives from which to look at this announcement.
To be sure, the Fed is starting to sound more concerned about inflation. “Transitory” no longer appears in the FOMC statement, and even Powell—who was a champion of the “transitory” perspective for most of the year—sounds concerned about the trajectory of inflation. Over the last two months, Powell’s comments along with those of Fed governors and regional presidents helped strengthen the dollar, slow down commodity price growth, bring inflation breakevens down, and led the markets to price in rate hikers much sooner and further than originally projected.
A faster taper accomplishes a few things. The first is that by moving the end of asset purchases forward, the Fed followed through on the hawkish forward guidance it started feeding to markets several weeks ago. It reassured markets that it took price stability seriously and that it would follow through on its forward guidance on asset purchases. It boosted the Fed’s credibility, so to speak, which is always a good thing. A perfectly credible Fed can govern by fiat. (get it?)
A faster end to asset purchases should also bring some comfort to inflation-wary market participants. A sooner end to purchases means a sooner start for rate hikes. Indeed, Wednesday’s announcements did nothing to stop inflation breakevens (expectations of future inflation) from continuing their month-long decline.
One interesting tidbit: the decline in 10 year inflation expectations (that is, the average inflation rate expected over the next ten years) came nearly entirely from a decline in expectations over the next five years, instead of over the five years following that (what pros call the five year-five year forward rate). That the shift in inflation expectations occurred in the shorter term (blue line) rather than in the longer term (green line) confirms that markets continue to see the Fed as getting ready to hammer out inflation.
At this rate (no pun intended), the first rate hike is all but certain to have occurred at/by June’s FOMC meeting. May’s meeting—on May the Fourth be with you-day, no less—has become the favorite in the fed funds futures market, with March not far behind. The Fed’s Summary of Economic Projections indicated that 12 FOMC potential FOMC members (not every respondent is technically on the FOMC at any given point) favored at least three rate hikes in 2022.
That works out nicely if the Fed hikes at every other meeting beginning in either May or June, but wouldn’t make sense if the Fed started in March. The only way for that to work out would be to hike after every two meetings (in March, July, and December). But if the Fed is so concerned with inflation that it plans to hike as soon as March, it wouldn’t really make sense for them to take rate hikes so slow.
The fate of FAIT
Another interesting bit out of Wednesday’s meeting was Powell’s comment during the press conference that today’s inflation isn’t really the sort of inflation that the Fed wants to see with its new framework. That is, the Fed wants to feel like it actually created the inflation instead of feeling like the victim of inflation. Inflation stemming from disrupted supply chains or fiscal policy isn’t good enough.
I found that a little bit bizarre for a few reasons that I’ll save for another time, but I’m glad that the Fed hasn’t attempted to respond to inflation with rate hikes. Situations like today’s show the difficulties with inflation targeting. If you truly believe inflation to be t̶r̶a̶n̶s̶i̶t̶o̶r̶y̶ temporary/short lived/not persistent, then raising interest rates doesn’t really make much sense. See this excellent piece from Gabriel Mathy, Skanda Amarnath and Alex Williams over at Employ America for an earlier example of transitory inflation that ended without the Fed moving at all.
This year has really shown the power of “flexible” in "flexible average inflation targeting” (FAIT), the Fed’s current framework, which aimes for inflation to average out to 2% in the longer run, with some “flexibility” for shortfalls in employment. The Fed didn’t have to respond to high inflation—which, to be fair, has persisted longer and been higher than most, including myself, expected—both because of FAIT and the forward guidance it inspired.
The Fed’s current interest rate forward guidance states that they will not raise interest rates until inflation is currently and projected to exceed 2% for some times and we’re at maximum employment. We can clearly check off that first requirement. I don’t think we’re quite there on maximum employment yet, but it’s clear that many at the Fed think we’re getting close. But the fact that the Fed doesn’t have to respond to inflation due to their self-permitted “flexibility” means that the Fed’s forward guidance lets them wait until they see maximum employment without worrying too much about inflation (for now).
In other words, FAIT is allowing the Fed to make the liftoff decision more or less entirely based on where they demarcate maximum employment in the labor market.
Wait, it’s all about credibility? (always has been)
Now let’s bring this back to the tapering process. If the Fed were perfectly credible (and could, for the life of them, give a coherent and understandable metric for what they consider maximum employment; see this for an excellent alternative), then markets would expect short term interest rates to remain at zero until whenever employment was forecast to reach whatever point the Fed announced as their maximum employment point.
This should sound pretty similar to what I said about quantitative easing. The effect of bringing the end of asset purchases forward is to move forward expectations for future rate hikes, since markets know the Fed won’t hike as long as asset purchases are ongoing. But wait: if the Fed could similarly convince markets that it would absolutely not, under any conditions, ever, for any reason, no matter who they’re with or where they’re going, ever raise interest rates until employment hit their maximum employment mark, wouldn’t that have the same effect as asset purchases?
In my view, pretty much. The Fed are fans of the portfolio balance channel and sees the purchase of each individual bond as being accomodation in and of itself, and it would disagree. But moving forward the end of asset purchases would be more or less equivalent to the Fed lowering its mark for maximum employment (or improving its forecast for employment growth).
One of many challenges for the Fed in the next few months will be how to communicate and justify what it judges as maximum employment. Since that’s the only part of the rate hike condition left to go, the Fed’s call on maximum employment more or less alone determines the timing of liftoff and will also help define how FAIT works in practice. Though the Fed is clearly very ready to move into a more active phase of the tightening tightening cycle, it has an opportunity now to work on communicating its maximum employment goal to markets. If it does so successfully, the end of asset purchases won’t cause too much trouble.
Therefore, a faster taper need not get in the way of labor market progress or that of the economy as a whole, as long as the Fed draws a good maximum employment line and can communicate that to markets.