The Federal Reserve is set to hold initial talks on shrinking its $120bn monthly asset purchase scheme, in a tricky first step towards dialling back the huge monetary stimulus it put in place during the pandemic.
The discussion is expected to begin as early as this week’s meeting of the Federal Open Market Committee and extend over the coming months, as officials weigh a stronger economic recovery and higher inflation data.
Jay Powell, the Fed chair, has signalled he would proceed with care and give ample warning about the US central bank’s plan for “tapering” bond purchases.
The Fed has said it would need to see “substantial further progress” towards its goals to start slowing its balance sheet expansion. While that standard may have been met on inflation, the labour market recovery has been less robust and filled with uncertainty.
Moreover, Fed officials do not want to repeat the experience of the 2013 “taper tantrum” — a sharp sell-off in Treasury debt triggered by the Fed’s plans to wind down its quantitative easing following the financial crisis.
“If you’re the person making the decision as Powell is, 2013 probably looms large for you — maybe larger than it should. You don’t want to be the author of another tantrum, that’s surely on their minds” said Jeremy Stein, an economist at Harvard University and a Fed governor at the time.
The US central bank has indicated that the tapering of asset purchases will not be dictated by any preset timeline, but by the evolution of the economy. It has set an even higher bar for raising interest rates from close to zero, where they have been since the start of the pandemic.
The Fed is in a relatively comfortable position heading into the tapering discussion, given the calm in financial markets. Equity prices are trading close to all-time highs and 10-year Treasury yields have dropped in recent weeks, even as inflation data has shown steeper price increases than expected.
“They have gotten the markets to believe that these very high inflation numbers are transitory. That’s exactly what they were hoping for. And they’ve achieved that,” said Randall Kroszner, a professor at the University of Chicago business school and a former Fed governor.
“That gives them a lot of runway to try to very, very gradually build expectations [on tapering], have discussions and debates. And then when the time comes, begin the move.”
But Powell will also be conscious that the Fed cannot move too slowly in terms of tapering. It risks being criticised for complacency if the recovery picks up even more rapidly than expected, and fears of overheating start to materialise.
“It’s just going from emergency accommodative policy to just very easy monetary policy . . . it’s time to start the descent,” said Rick Rieder, chief investment officer of global fixed income at BlackRock. “Markets would feel much better knowing that the fasten seatbelt sign is on and we could start to land”.
Ian Shepherdson of Pantheon Macroeconomics said markets should be “fairly resilient” in the face of Fed tapering.
“It’s becoming much harder now to justify continuing QE trillion dollar annualised rates when the economy is obviously rebounding strongly,” he said.
“Fiscal policies are super accommodative and the fundamentals are way, way stronger than they were in 2013 when the echoes of the crash of 2008, were still really quite loud. So this is a different planet.”
Moving too aggressively towards a taper would carry its own perils, said Stein. It might undermine the Fed’s message that inflation is under control and the labour market is far from fully healed.
“The Fed has been trying to make the case, I think reasonably convincingly, that a lot of this inflation is transitory, it’s nothing to really get too agitated about. The risk is that if they move the taper up now the market takes this as a signal that they’re starting to see something a little bit more permanent on inflation, he said.
As recently as April, Powell insisted the Fed was not even thinking about a discussion on tapering, but in recent weeks top central bank officials have signalled that the central bank would be ready to proceed with the discussion in the coming meetings.
Even if tapering is not a formal agenda item at this week’s FOMC, the first discussions about it are expected to take place on Tuesday and Wednesday.
There are plenty of details to iron out, including the timing and conditions of the taper, as well as the speed and composition of the drawdown in asset purchases. Some economists are calling for the Fed to reduce the pace of mortgage-backed securities purchases before Treasury bond purchases, given the booming state of the housing market.
But Powell is unlikely to reveal many specifics of the plan until the economic picture is clearer, most likely not before the August Jackson Hole conference in August.
“There will be an acknowledgment that they started to have a conversation about what the potential path for asset purchases will look like. But they will reiterate that it will still be some time before substantial further progress has been made,” said Michelle Meyer, a senior economist at Bank of America.
“That will make it clear that they are being responsible, that they are trying to plan ahead”.