Federal Reserve Chair Jerome Powell heads into what could be his last year atop the central bank determined not to repeat the mistake he made when he was a neophyte monetary policy maker seven years ago.
Then a Fed governor, Powell was among those leading the charge to scale back the central bank’s quantitative-easing program -- a stance that led to the economically debilitating and market-wrenching taper tantrum of 2013.
Powell, whose four-year term as chair ends in February 2022, is likely to sound more cautious this week about curbing the Fed’s massive asset purchases -- even though the economic outlook has brightened further thanks to an expected big budgetary boost from President Joe Biden.
“He’ll emphasize that the risk of moving too early far outweighs the risk of moving too late,” said Lou Crandall, chief economist at Wrightson ICAP LLC. Powell will hold a press conference on Wednesday after a two-day meeting of the Federal Open Market Committee that is expected to decide to keep monetary policy ultra-easy to fight the economic fallout from the pandemic.
As 2013 showed, getting the timing of a taper right can be critical. After then-Fed Chairman Ben Bernanke suggested in May of that year that the central bank might soon begin to rein in QE, long-term interest rates shot higher, upending emerging markets and restraining the U.S. economy. Bernanke’s comments came just weeks after an FOMC meeting in which Powell voiced hopes that the Fed might start scaling back asset purchases in June, according to a transcript of that gathering.
“Could the Fed taper without a tantrum?” JPMorgan Chase & Co. Managing Director John Normand and fellow strategists asked in a Jan. 22 note to clients. Their answer: It’s “unlikely given current valuations and positioning” in financial markets.
A Bloomberg survey of economists last week revealed a wide dispersion of views about when the Fed will begin to rein in its buying. While a plurality of 35% expect the taper to start in the first three months of next year, just over a quarter believe it will come in the final three months of 2021. Roughly another 25% don’t see it happening until the second quarter of 2022 or beyond.
The Fed is buying a lot more bonds today than it was seven years ago. It’s currently purchasing $120 billion per month -- $80 billion of Treasury securities and $40 billion of mortgage-backed debt -- compared with $85 billion monthly in 2013, including $45 billion of Treasuries.
But just as was the case back then, the Fed has set a rather amorphous guideline for QE policy. In 2013, the FOMC said it would continue buying bonds “until the outlook for the labor market has improved substantially in a context of price stability.” Now it says it will purchase at least $120 billion of assets monthly “until substantial further progress has been made toward the committee’s maximum employment and price-stability goals.”
As Powell noted seven years ago, such vague guidance increases the risk that the markets misunderstand the Fed’s intentions. “The lack of clarity around our stopping rule for asset purchases is itself a financial-stability risk,” he said at the March 2013 FOMC meeting, just months before Bernanke’s comments shook the markets, according to the transcript of the discussion.
Like they were in 2013, investors could again be surprised in the middle of the year by the strength of the economy, this time as a result of more widespread vaccinations, said Robin Brooks, chief economist for the Institute of International Finance. A bond-market sell-off could be aggravated by a ramp-up in Treasury debt sales as the government finances fiscal stimulus.
“They may get run over just by how quickly markets may move,” Brooks said of the Fed.
Potential Change
Another similarity between 2013 and today: A potential change in Fed leadership. Bernanke was on his way out seven years ago and nervousness about his potential successor may have contributed to the slide in the bond market, according to Brooks.
As 2021 wears on, the financial markets are likely to focus more on Powell’s fate. That could compound inflation jitters among investors by increasing uncertainty about future policy, said Mellon chief economist Vincent Reinhart.
For what it’s worth, economists expect Powell to remain at the Fed: About three-quarters of those surveyed by Bloomberg said they expect Biden to offer him another term.
The Fed chairman has acknowledged that his fears in 2013 about the risks posed by QE proved to be misplaced.
“The taper tantrum left scars on anybody who was working at the Fed at that time,” Powell told the 2019 annual meeting of the American Economic Association. “I was one of those who raised concerns when I first got to the Fed” about asset purchases. While “it was appropriate to raise them, they didn’t really bear fruit. We didn’t see high inflation. We didn’t see asset bubbles,” he said.
The take-away from the episode is that “markets can be very sensitive to views about the balance sheet,” he added.
What Bloomberg Economics Says:
“BE expects the overarching theme of the January meeting to be consistent with Powell’s recent public comment that this not the time to talk about a policy exit. Instead, he will stress that the Fed stands ready to provide additional support to the economy, predominantly through even more aggressive asset purchases.”
-- Carl Riccadonna, Yelena Shulyatyeva, Andrew Husby and Eliza Winger. For full note click here
That’s why he’s now promising to give investors plenty of time to digest a potential change in policy.
“We’ll communicate very clearly to the public and we’ll do so, by the way, well in advance of active consideration of beginning a gradual taper of asset purchases,” he said in a Jan. 14 webinar.
Despite such efforts, a sharp increase in long-term interest rates is “virtually inevitable,” according to former New York Fed President Bill Dudley. As the Fed scales back and eventually eliminates its bond purchases, investors will demand higher yields to fill the void, the Princeton University senior research scholar wrote in a Jan. 21 Bloomberg Opinion column.
“There’s no reason for the tantrum to be unduly damaging,” provided the Fed is prepared to respond if necessary by halting the taper or delaying its initial interest-rate increase, Dudley added. “It just will feel bad relative to the quiescent bond market we have experienced since the beginning of the pandemic.”
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