Apart from covid and inflation, one of the most talked-about issues in financial markets these days is the Fed’s “taper.” People reference the “taper tantrum” of 2013, a period of market turmoil that many think could be upon us. What exactly is the “taper” we are now facing? Should investors be concerned? More generally – what should we expect from Fed policy as we finally move past covid?
After more than a year of tremendous support, the Fed is now beginning to gradually tighten monetary policy. The Fed sees the US as having made “substantial further progress” in recovering from covid – namely, recouping about 50% of the jobs lost, with inflation at or above 2% – to warrant removing some accommodative measures. However, the evidence suggests we are not on the cusp of substantial policy tightening.
What is the Taper?
Tapering refers to the Fed’s gradual reduction in the amount of assets – both Treasury and mortgage securities – it purchases each month. The Fed has been purchasing a combined $120 billion of Treasury and mortgage securities every month to provide liquidity and help keep interest rates low in support of the US recovery from covid.
The Fed appears set to announce the official roll-off of this support, gradually reducing purchases late this year by approximately $15-20 billion per month. This would put the end date of these purchases at mid-2022. Different than the “taper-tantrum” of 2013, however, is the fact that this taper has been highly telegraphed. The 2013 turmoil was largely seen as a result of an unexpected announcement to taper. The Fed has learned from past experiences, and made an outsize attempt to prepare the market for this coming taper. Having been digested for months, it doesn’t appear to be an event that should cause outsize pressure in markets.
What About Interest Rates?
Perhaps more important than the Fed’s asset purchases has been the Fed’s anchoring of its benchmark Fed Funds rate at 0. This has served to keep yields on fixed income instrument extraordinarily low, boosting valuations for equity markets and overall demand for risk assets.
In yet another example of the Fed having learned from its past mistakes, the Fed refined its policy objectives in 2020 and determined that the US must achieve inflation at (or above) its 2% target, and maximum employment, before it will consider tightening interest rate policy. Moreover, the Fed is willing to accept inflation over its target for an extended period, aiming rather for average inflation over time at its target. And generally speaking, the Fed changed its policy to be more backward looking – that is, waiting for data to confirm economic strength – rather than pre-emptive.
This harkens back to lessons learned from late 2018, where the Fed began to significantly tighten policy in the face of stubbornly low (but slightly increasing) inflation and some growth (with low unemployment). In essence, the US economy was possibly showing signs of finally achieving decent growth, and the Fed wanted to get in front of the curve and tighten policy before anything got too hot. This had been its historic stance, and was often coincident with an ultimate downturn in the US economy. Indeed, late 2018 saw significant turmoil from Fed tightening, which caused the Fed to immediately about-face and bring the Fed Funds rate back down to 1.5% from 2.5%.
Challenges Facing the Fed
So, what might we expect from Fed interest rate policy heading out of covid?
Inflation has been running well above the Fed’s 2% target, which the Fed (and we at MACM) largely believe is due to transitory factors – supply chain issues, for example, among other things. However, some signs appear to be cropping up that inflation may be stickier. Home prices and rents have been soaring, for example, which collectively make up about 30% of the inflation index. These increases should ease, but likely won’t reverse course. While the Fed has clearly stated its dual mandate – meeting both inflation and employment targets before it considers raising interest rates – we have to wonder how much inflation the Fed is willing to stomach before it considers taking action to raise rates in response.
Overall, however, we anticipate inflationary pressures will ease back to the low levels present for over a decade precovid as transitory factors subside. We further don’t see the Fed ultimately breaking from its guidelines and raising rates based upon meeting one of two required criteria.
Unemployment is the other piece to the puzzle. With unemployment near 5%, we seemingly may not be too far off from Fed’s target of maximum employment. In 2018, for example, unemployment was in the 3% range with the Fed raising rates.
Generous unemployment benefits have kept people sidelined who have been, in many cases, enjoying more income from unemployment than they’d have had while working. Concerns about covid in the workplace have also kept people from working, as has the difficulty for many to find childcare amid school and other closures. As we fully reopen, with extraordinary unemployment benefits expiring this past September, it is likely that the unemployment rate should tick down somewhat.
However, this seems unlikely to cause the Fed to raise rates in the near term.
Bolstered by the wealth effect of soaring asset prices, many folks have left the labor force and simply retired early (perhaps also not interested in dealing with covid and the workplace). Estimates show that we’ve seen two times the number of typical retirees since the onset of covid. This has artificially depressed the level of unemployment by reducing the working population.
Moreover, the excess savings of the average consumer through the pandemic (both through less spending and stimulus programs) means the unemployed may not be in any particular rush to find jobs. Indeed, the most recent payrolls report missed estimates by a significant amount, despite being the first month following the roll-off of extraordinary unemployment benefits.
All told, we may not be on the cusp of employment levels that satisfy the Fed’s criteria of “maximum employment.” People may be slower to return than expected, and the level of unemployment consistent with “maximum employment” may be lower than before, given the reduction in the working population.
While the Fed is set to begin tightening policy, it does not seem to be on the brink of any significant raise in interest rates that might be a shock to the economy and markets. Moreover, even if the Fed were to begin raising rates, we are merely coming off of rock-bottom levels. While this may make fixed income incrementally more appealing, this scenario remains generally favorable for equity markets overall. The Fed seems to have learned its lessons from the past, and would rather be late than early in tightening its policy, letting the economy run hot for some time. And, to be sure, the Fed intends to continue to telegraph any moves well in advance, so there shouldn’t be any true surprises. Indeed, keeping an eye on the inflation/unemployment paths and their implications for Fed policy is certainly top of mind here at MACM.