Fed tiptoes towards the taper stage months before the curtain call

Officials’ opening discussion about how and when to taper the U.S. central bank’s $120 billion in monthly bond purchases looks set to occur at this week’s two-day policy meeting and will take place against a dramatically different backdrop than the last time around, when they were more skittish about owning such a substantial slice of the bond market.

“I think the discussion will start” at the Fed’s policy meeting on Tuesday and Wednesday, said Robin Brooks, chief economist at the Institute of International Finance. “I think it will start very, very cautiously,” he added, and Fed Chair Jerome Powell won’t be in any rush to conclude it.

The risk of another “taper tantrum” – the market ruckus that erupted eight years ago when Fed policymakers first broached the notion of scaling back their bond-buying after the 2007-2008 financial crisis – appears remote this time. Fed officials have posted plenty of trail markers for the path to tapering, and key officials have signaled the discussion is underway in the background. Markets so far have taken it all in stride.

The Fed said in December that it would continue to buy $80 billion in Treasuries and $40 billion in mortgage-backed securities (MBS) each month until the economy made “substantial further progress” towards the central bank’s full employment and 2% inflation goals. The bond-buying puts downward pressure on longer-term borrowing costs to encourage investment and hiring.

While there has been plenty of progress in slowing the coronavirus pandemic, largely due to a widespread vaccination program, U.S. employers have added fewer than half of the 2 million jobs that Powell had suggested he was hoping for after the Fed’s April policy meeting.

Fear of contracting the virus, a pandemic-driven job market reshuffle and extra unemployment benefits are among the factors keeping workers from jobs even as firms try to staff up ahead of an expected summer boom. More than 9 million Americans are unemployed.

Meanwhile, inflation has come in hotter than expected, though the gains have been driven by factors that are expected to be transitory, such as the global semiconductor production bottleneck.

“We have a lot of weird things going on right now,” said Alejandra Grindal, chief international economist at Ned Davis Research. “It will take quite a few months until these issues become resolved and we can determine whether they are more than transitory.”

Most economists in a Reuters poll released last week said they expected the Fed to take until at least August to flag a timeline for tapering, with no actual reductions in asset purchases until early next year.

DIFFERENT ECONOMY, DIFFERENT FRAMEWORK

Compared with the last time the Fed was contemplating reducing its bond purchases, the U.S. economy is arguably in better shape. The unemployment rate is lower, overall national output is closer to its pre-crisis trend, and stronger tailwinds, including $2.8 trillion of pandemic-related government aid in the past six months, are setting up what’s expected to be the fastest economic growth in decades this year.

But the Fed still seems less eager to ease up on the monetary policy gas pedal than it was eight years ago.

One reason is that most central bankers, once wary of the costs of quantitative easing and eager to stop such stimulus as soon as possible, have become more accustomed to the idea that bond-buying is a part of their toolkit. A big balance sheet, viewed as a problem to be fixed back when holdings totaled about $4 trillion, is no longer a particular cause for alarm, though it is now twice as large.

Additionally, since last year the Fed has operated under a new framework in which it now aims to get inflation a bit above 2% to make up for long periods of below-2% inflation, and to fix any shortfall from broad-based and “inclusive” full employment without a counterbalancing concern over overshooting that goal.

“It’s a different Fed, it’s a different framework,” said Gregory Daco, chief U.S. economist at Oxford Economics.

LONGER-TERM PLANNING

Fifteen months after the Fed slashed its benchmark short-term interest rate to zero and began buying bonds to shore up the economy and financial markets, it is not likely to touch the policy dial this week. Powell is likely to use his post-meeting news conference to emphasize, as he has done for months, that the economy is still a long way from a full recovery.

Even so, policymakers will want to start talking through what benchmarks they’d want the economy to meet before trimming the asset purchase program, Daco said, including measures of labor force participation and employment levels in addition to the unemployment rate, now at 5.8%.

In 2013, Fed policymakers aimed to complete the taper by the time unemployment had dropped to 7%.

Once underway, the tapering may proceed differently. Instead of reducing the pace of purchases of both kinds of assets evenly, the Fed may phase out its MBS purchases more quickly, if the findings of the Reuters poll last week are a guide.

However it plays out, Wall Street economists generally see the taper taking about a year to complete, similar to last time. But at that point they expect the Fed to wait just six months before raising interest rates, half as long as last time, the New York Fed’s April survey of primary dealers indicates.

None of this longer-term planning, though, is yet expected to be part of the Fed’s discussions.

The central bank is due to release fresh quarterly economic forecasts on Wednesday that will show policymakers’ evolving views of the outlooks for unemployment, inflation and economic growth, as well as the likely date of a first rate hike.

The last forecasts, released in March, showed that most policymakers did not expect a liftoff on rates before 2024. Analysts expect no change on that front this week.