Can the US Federal Reserve Taper and QT this time around?

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by Shaun Richards

A feature of 2021 so far has been the discussion over what the US Federal Reserve will do next? One factor in this has been the extraordinary amount of monetary stimulus it has pumped into the US economy with near zero interest-rates and a balance sheet expanded to just shy ( 7.92) of 8 trillion US Dollars. That compares the the previous peak of around 4.5 trillion back in 2015. On Monday the New York Fed gave us its view on what may happen next.

The exercise suggests that the SOMA portfolio could grow
through ongoing asset purchases to reach $9.0 trillion by 2023, or 39 percent of GDP. The portfolio is then assumed to be held constant, with proceeds from maturing securities being reinvested. After that point, the path of the portfolio will depend on choices made regarding the portfolio as the FOMC normalizes the stance of monetary policy.

These days normalizes does not mean what it did as those who recall its use back in 2018 or so will recall it meant interest-rates of around 3%. The reason for the expected expansion in the balance sheet is that the New York Fed is still buying at a fairly rapid rate.

In addition, the Federal Reserve will continue to increase its holdings of Treasury securities by at least $80 billion per
month and of agency mortgage‑backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum
employment and price stability goals.

The Economic Outlook

For this quarter we are being told this.

The New York Fed Staff Nowcast stands at 4.6% for 2021:Q2.

Later this afternoon the numbers for the first quarter will be revised and the New York Fed is expecting an increase to over 6%. The numbers are annualised but in our terms a bit over 1% and then around 1.5% are strong numbers. This has been added to by the Markit IHS business survey.

Adjusted for seasonal factors, the IHS Markit Flash
U.S. Composite PMI Output Index posted 68.1 in
May, up from 63.5 in April. The rate of expansion
was unprecedented after surpassing April’s
previous series record.

They went further.

At the same time, new export business rose at the fastest pace since the series covering both manufacturing and services began in September 2014.

Mostly we have seen manufacturing pick up and services lag but the US has moved beyond this according to Markit.

The seasonally adjusted IHS Markit Flash U.S.
Services PMI™ Business Activity Index
registered 70.1 in May, up from 64.7 in April. The
rate of expansion was the sharpest since data
collection for the series began in October 2009.

So the outlook for 2021 looks to be singing along with the Black Eyed Peas.

Boom boom boom
That boom boom boom
That boom boom boom
Boom boom boom

Inflation

We have previously looked at an inflation rate ( CPI) of 4.2% and house price rises in double digits. The Markit survey above reinforced curreny concerns here.

Inflationary pressures continued to mount in May,
as rates of increase in input prices and output
charges quickened to the steepest on record.
Companies commonly noted efforts to pass through
soaring costs to clients, with prices of oil, PPE and
transportation often cited as fuelling the uptick in
expenses.

They think this will be felt in the consumer inflation numbers.

Average selling prices for goods and services are both rising at unprecedented rates, which will feed through to higher consumer inflation in coming months.

Forward Guidance

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Remember when we were supposed to listen to the open mouth operations of central bankers so we would be better informed about interest-rates? That went really rather wrong. But we can look at what is being said by central bankers who seem to have forgotten that. On Tuesday Mary Daly of the San Francisco Fed was interviewed by CNBC.

“We haven’t seen substantial further progress just yet. We’re still looking for substantial further progress,” Daly said during a live “Closing Bell” interview. “What we’ve seen is some really bright spots, some very encouraging news. It gives me hope, and I am bullish for the future. But it’s too early to say that the job is done.”

As to policy she told them this.

“We’re talking about talking about tapering, and that is what you want out of us. You want to be long-viewed here,” she said. “But I want to make sure that everyone knows it’s not about doing anything new. Right now, policy is in a very good place. Policy is supporting the American people.”

God knows where she is going with “talking about talking…” but what we see here is quite a revision of central bank behaviour which is supposed to look ahead along the lines of the famous take away the punch bowl as the party gets started statement. Whereas Mary seems to want to wait with the risk that the party is over before she does anything.

Vice Chair Randal Quarles spoke yesterday and he seemed quite keen on the house price rises.

Highly accommodative monetary policy by the Federal Reserve has fostered strong growth in interest rate–sensitive sectors of the economy such as housing and durable goods, offsetting some of the historic weakness in the service sector last year.

That is at least more honest than the Bank of England as we recall Sir John Cunliffe turning his blind eye to this issue last week. He also brought in the issue of the fiscal stimulus which is in play in the US.

Even as personal consumption expenditures rose at a huge 10 percent annual rate in the first quarter of 2021, the saving rate averaged 21 percent over those three months. Again, a lot of that reflected the most recent round of stimulus payments.

Then something else which would have in the past led his predecessors to raise interest-rates.

The underlying strength in hours and wages lends support to widespread reports that worker shortages are impeding hiring. Labor force participation remains about 3‑1/2 million people lower than before COVID-19.

But he has no such intention.

In contrast, the time for discussing a change in the federal funds rate remains in the future

Only some sort of vague promise to maybe look at tapering or QE reductions at some future date.

If my expectations about economic growth, employment, and inflation over the coming months are borne out, however, and especially if they come in stronger than I expect, then, as noted in the minutes of the last FOMC meeting, it will become important for the FOMC to begin discussing our plans to adjust the pace of asset purchases at upcoming meetings

Comment

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There are three especially significant starting points for all of this. The US Federal Reserve is the world’s most important central bank due to the size of the US economy and the reserve currency role of the US Dollar. Also the US economy is presently leading us out of the Covid-19 economic malaise. Finally whilst other central banks have reduced purchases of bonds and the flow of QE it is the only one to have cut back the amount or apply Quantative Tightening or QT in 2017-19 when some US $700 billion was pruned.

But now as you can see it looks to be scared of its own shadow and unsure of its role. It raised its inflation target on dubious grounds and now finds that if April was any guide it has underestimated the push the reopening would give it. It seems to be hanging onto QE on two grounds. Fears for what would happen to the US bond market and in case the economy dips at any point. Along the road we are seeing policy swing both ways. Firstly as has been discussed in the comments the market situation has applied a sort of short-term QT.

Demand for an overnight funding through the Federal Reserve Bank of New York’s overnight reverse repo program (RRP) has begun to flirt with recent records highs, after almost no one used it for months.

Daily repo usage jumped to $450 billion on Wednesday, its highest level since the December 30, 2016, according to Fed data. ( MarketWatch)

This is in many ways a response to the fact that some short-term interest-rates rather than rising as you might expect have fallen to 0% in response basically to all the cash in the system.

Another way of looking at all of this is that just as you might reasonably have expected US bond yields to be rising ( the recovery plus inflation) if anything they have drifted lower. Back on the 17th of March when we looked it was 1.63% whereas now it is 1.58%.

If we step back the issue post credit crunch was that they would delay taking the stimulus away. So we are on the verge of the same mistake.

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