Avoiding Turbulence: Fed Policy and Communication in 2021

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.