Don't Fear The Taper

Long, long ago, even before the 2008 global financial crisis, the world’s central bankers, including the Fed, shifted their focus from trying to fight inflation to trying to create it. As we know, however, that pursuit of the holy grail of 2% has taken more than a dozen years, and now that we appear to be there, and well beyond it, in fact, the Fed refuses to believe it.

Ever since the economy began reopening earlier this year, the U.S. year-on-year inflation rate has been rising steadily and strongly, well above the Fed’s 2% target. In May, the YOY rise in the consumer price index hit 5.0%, while the core index, which excludes food and energy prices, rose 3.8%. Looking ahead, it’s hard to see inflation easing anytime soon, given the trend in rising worker’s wages, which once on the books are going to be hard to pull back, especially given the dearth of workers relative to job openings. Prices are also rising due to strong pent-up demand that is far outpacing the supply of goods, due partly to the lack of workers.

Yet Fed Chair Jerome Powell continues to insist that this recent surge in inflation is “transitory,” a mere temporary reaction to the economic reopening.

Is he saying that because he really believes it, or because he’s worried what will happen if the Fed starts to turn down the juice, even a little bit, and with a fair warning?

In his defense, three straight months of higher-than-normal inflation, at least compared to the past 20 years or so, probably isn’t a reason to think that inflation is “sticky.” Let’s see what happens over a prolonged period, as the Fed says it will do itself before it starts to tighten monetary policy by either raising interest rates or to reduce its mammoth purchases of government and mortgage debt, or both.

After all, while inflation is indeed heating up, the Fed is more focused on the job market, which has improved massively over the past several months but is still well below what it was before the pandemic-induced lockdown in early 2020. Last month, the unemployment rate edged up to 5.9%, down from 11.1% a year earlier but still 2.4 percentage points above the 3.5% rate it stood at in February 2020, just before the government shut down most of the economy. In addition, new jobless claims are down more than 50% since the beginning of April, but they’re also about 50% higher than they were before the lockdown. So, in the Fed’s mind, they still have a lot of work to do.

That’s not even considering what the financial market reaction would be if the Fed started tightening policy. Can you say “taper tantrum”?

However, the odds of that happening seem pretty remote.

The Fed has indeed started to make noise about pulling back on some of its largesse. After last month’s monetary policy meeting, the Fed said it didn’t expect to raise interest rates until 2023, a slightly more hawkish stance than its March forecast. According to its newest “dot plot” projections, 13 of 18 voting members expect to raise short-term rates twice by the end of 2023, up from seven voters in March. Since then, of course, at least four regional Fed presidents said they expect to have to raise rates even before that, like maybe sometime next year. At the same time, they’ve discussed the possibility of reducing their purchases of mortgage-backed securities, now running at $40 billion a month, while not tapering their purchases of Treasury debt, which total $80 billion a month.

Which is probably the main reason why you shouldn’t worry about any serious tapering any time soon.

While the focus of many people is currently on rising inflation as a sign of where Fed policy is going next, the markets probably should direct their concern on something else, namely the federal deficit.

Whenever the word “accommodation” is used to refer to the Fed, it usually involves what the Fed is doing to promote private business activity, like making it easier and cheaper for businesses and consumers to borrow money. However, the Fed is also accommodating the biggest borrower of all, namely the federal government. It simply cannot pull back on its easy-money policies without causing government borrowing costs to rise. That’s not the Fed’s mandate, but it is what it’s doing.

Inflation could easily rise to double-digit percentages without Fed accommodation, both in terms of ultra-low interest rates and massive buying of Treasury bonds to soak up all that deficit spending. But federal spending, whether it’s purportedly for pandemic relief and recovery or good old-fashioned pork, is here to stay. And so is the Fed, inflation or not.

So relax; the Fed isn’t going anywhere.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.