Fed Preview: Time To Taper

In this Issue:

The Federal Open Market Committee (FOMC) will be gathering next week to take stock of monetary policy. The main question to be addressed is whether to begin reducing the central bank’s purchases of securities. The Bank of Canada began the tapering process earlier this year; the Reserve Bank of Australia and the European Central Bank both announced plans to follow suit earlier this month.

If we had a seat on the FOMC, we would be in favor of easing off of the accommodative policies, for the following reasons:

  • The growth outlook is strong. As reflected in our updated U.S. forecast, activity is expected to recover from a late summer slump. COVID-19 cases appear to have peaked, which should reduce hesitation among consumers to gather and travel.
  • Labor markets are on track to meet the Fed’s expectations. There are an immense number of job openings available, wages are rising, and unemployment benefits are shrinking. Those still on the sidelines should be back in the game soon.
  • Inflation risks are to the upside. Few think that the price level will continue increasing at a 5% annual pace, which it has over the past twelve months. But excesses of demand over supply and kinks in global supply chains may prevent inflation from settling down soon, or completely.
  • Liquidity in the financial system is more than sufficient. Credit demand is modest, and evidence of excess cash can be seen in many different places. Financial conditions are easy. Leaving too many reserves in the system could foster unwanted inflation in the prices of goods or assets.
  • The market is ready. The Fed has been dropping hints about reducing bond purchases for two months, and long-term interest rates haven’t budged. A repeat of the 2013 “taper tantrum” seems highly unlikely.

Chart: A balance sheet for the Fed's decision

The statements and forecasts following next week’s conclave should set the stage for a tapering announcement at the November 2-3 FOMC meeting. The pace of tapering will start small and potentially increase over time. Interest rate increases are still at least a year off, although the Fed’s dot plot will likely show more members calling for more hikes sooner than they did in June.

Following are additional details on the factors the group will consider, with both sides of each issue presented.