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The Fed: With Fed officials split over outlook, Powell seeks to find compromise tapering plan

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With the U.S. economic outlook rife with uncertainty, it is no wonder that Federal Reserve officials are divided about the stance of central bank monetary policy.

Fed officials are facing a hard reality — “economic growth is coming in weaker than forecast, while inflation is coming in hotter,” said Diane Swonk, chief economist at Grant Thornton.

The central bank’s ultra-easy policy stance, in place since the pandemic struck the economy in March 2020, looks untenable. With this spike in inflation this year, the consensus is that it’s time to back away from all the stimulus.

But the question of how and when to back away has divided officials.

The Fed has been buying $80 billion of Treasurys and $40 billion of mortgage-backed securities each month since last June to keep long-term interest rates low and bolster demand. It said it would maintain the purchases until the economy hit a threshold of “substantial” progress on inflation and the labor market.

Since the summer, the Fed has been talking about slowing down and eventually ending these purchases. Officials have tried to stress that this question is “divorced” from the separate question of when to raise interest rates off the current close-to-zero level.

Although not an exact science, roughly half of the Fed’s 18 top officials support tapering “sooner rather than later.” They think the economy has met the threshold of “substantial” progress and is now being bedeviled by supply bottlenecks, something the Fed’s asset purchases can’t solve.

The other half of the Fed leadership have said they would like to see more data on the labor market before the threshold for tapering is met. They think it is still important to support demand in coming months as the economy regains its footing in the wake of the coronavirus. 

So Fed Chairman Jerome Powell faces the tough task at the Sept. 21-22 policy.meeting of trying to craft an exit plan that satisfies both camps.

“Powell is in a corner,” said Swonk.

The likely compromise, Wall Street economists say,  is for the Fed to signal that if the economy continues down the recent path, the threshold for substantial further progress will be met later this year.

Powell said as much in his speech to the Jackson Hole conference late last month.

Ellen Zentner, U.S. economist at Morgan Stanley, thinks this signal that the Fed is close to tapering will be followed by an announcement in November that the economy has cleared the hurdles needed to taper. The actual slowing down of purchases will begin in December.

Other economists, like Michelle Myer, chief U.S. economist at BofA Securities, think the Fed will announce and begin the tapering of asset purchases in November. 

Fed officials who want to start tapering sooner — so called “hawks” — will go along with this plan, Zentner said.

The true aim of the hawks advocating for an earlier taper was to “make sure that the timeline [for tapering] doesn’t slip into next year,” said Zentner.

The hawks on the Fed want the tapering to start this year because they hope the purchases are ended by the middle of 2022. That would give the central bank room to raise interest rates later that year, if needed.

The Fed plan will stress that the reduction in the pace of purchases could pick up if the economic data signal a need for a faster exit. 

But the growing splintering among Fed officials can’t be papered over entirely. It will show up in the updated interest rate “dot plot” that will feature earlier and faster tightening expectations among some officials, said Kathy Bostjancic, chief financial economist at Oxford Economics. 

It will only take two members of the Fed to change their minds for the Fed to expect one rate increase in 2022.

The signal of a rate increase in 2022 would create a communications challenge for Powell as he would try to decouple the timing of rate increases from the timing of rate liftoff, Bostjancic added.

Aneta Markowska, chief economist at Jefferies, agreed: “The argument that tapering does not imply tightening will be more difficult to defend.”

The Fed will also publish dots for 2024 for the first time. Jefferies expects the dots to show three rate increases in 2023 and 2024, which would bring the fed-funds rate up to 1.625%.

The yield on the 10-year Treasury note
TMUBMUSD10Y,
1.371%

has edged up to 1.37% this week, still well below the 1.75% rate seen in early April.

However, the Dow Jones Industrial Average
DJIA,
-0.48%

is on track to be down for the third straight week, in part because of all the taper talk.

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