The January FOMC (Federal Open Market Committee) meeting was uneventful. As expected, the Fed left policy unchanged, and only made small changes to the FOMC statement to reflect the recent economic weakness related to the resurgence in COVID-19 cases. In his press conference, Fed Chair Jerome Powell struck a balance between emphasizing the current economic weakness and an improved economic outlook, while reiterating that the current highly accommodative stance of monetary policy is appropriate to maintain the economic recovery. Underscoring this point, Powell said, “We’re going to remain accommodative until we see improvement in the economy and not just in the outlook.” And in terms of how this cautious approach relates to asset purchases, Powell suggested it would be “quite some time” before substantial further progress is met – the trigger for the Fed to start to reduce the monthly pace of purchases.
Because of the outlook for highly expansive U.S. fiscal policy, many market participants have shifted focus to the Fed’s exit strategy. According to Powell, however, it is premature for the Fed to start publicly discussing any shift toward less accommodation. Nonetheless, we think the Fed is planning for a range of scenarios, including one in which it will eventually be appropriate to start to gradually reduce accommodation. At that time, as the Fed starts to discuss its eventual exit, it will want to avoid a premature tightening in financial conditions. And while some commentators have raised the specter of another “taper tantrum,” we think the Fed can successfully engineer a smooth shift in monetary policy, when it does become appropriate.
Wait and see
Since we now expect significant additional fiscal spending early in 2021 (see our recent blog post, “A Narrowly Democratic Congress Could Boost Spending and Growth”), which should bolster the U.S. economy and employment, PIMCO now sees a risk that the Fed begins tapering bond purchases a few months earlier than previously expected – that is, in late 2021 instead of early 2022. And based on Fed official communications since the December FOMC meeting, that view is shared by some of the Fed regional bank presidents. That said, the Fed’s leadership has done its best to reassure markets that it will not prematurely begin to remove accommodation. And with the economy still recovering from the pandemic, we believe those assurances are appropriate to help anchor interest rates and keep the recovery on track. Indeed, if hypothetically the bond markets were to bring forward expectations of policy tightening similar to the 2013 taper tantrum, an ensuing rate sell-off could potentially negate some if not most of the positive economic benefits of the federal government’s policies.
Along these lines, we think the Fed could wait until any changes in fiscal policy have become law (or are very close to becoming law) before fully incorporating them into the official economic projections and, in turn, into their policy views. As a result, markets may have to wait until the Fed’s June 2021 forecast to see how officials are digesting the new pandemic relief legislation likely to pass in the spring. This, in turn, gives the Fed more time to monitor the path of the virus, including vaccine distribution. It also provides time to carefully prepare communications that balance the improved economic outlook with still fragile current conditions and helps explain why Powell was not in a rush to provide additional guidance at the January FOMC meeting.
Three approaches to forestalling a tantrum
While a high degree of monetary accommodation is still warranted now, eventually Powell will need to start communicating the Fed’s plans to begin winding down its asset purchases, especially if the U.S. economy makes substantial progress this year toward the Fed’s inflation and employment goals. When this time comes, the Fed will want to communicate in ways that generate a smooth exit with a gradual rise in interest rates. We see three approaches:
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The New Neutral: The Fed can emphasize that the real neutral interest rate remains low, and may well be even lower after the pandemic-related recession, despite policymakers’ efforts to minimize longer-term economic scarring. The low real neutral interest rate should serve as an anchor for longer-term interest rates.
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Two distinct and separate policies: Fed officials should once again try to disentangle changes in their asset purchase programs with market expectations for the timing of changes in the policy rate. Based on our interpretation of the current guidance, economic conditions needed for changes in asset purchases are sufficiently distinct to allow some disconnect between the two. If the Fed can anchor rate expectations at the same time it begins to reduce bond purchases, we think it should be able to limit the bond market sell-off.
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Communicate well in advance and in detail: The Fed should communicate early any plans to wind down the asset purchase programs, perhaps by releasing a pre-set tapering schedule, as it did ahead of the 2017 balance sheet reduction program. Indeed, by communicating that program well in advance, the Fed managed to minimize bond market disruptions associated with more Treasury supply.
Last year, the Fed updated its monetary policy strategy to emphasize the need for a period of above-target inflation after periods of economic weakness. This new strategy, which asymmetrically focuses on maximum employment while downplaying the risks of higher inflation, should also ultimately serve to anchor market expectations for the path of interest rates, while fostering a smooth and gradual exit from extraordinary Fed policy. Still, markets can overshoot from time to time – and clear and careful Fed communication would help minimize the likelihood or impact of such events so the economy can continue to heal.
Tiffany Wilding is a PIMCO economist focused on North America and a regular contributor to the PIMCO Blog.
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