At the Jackson Hole symposium on Friday 27 August, US Federal Reserve Chair Jay Powell outlined plans, the details of which are yet to be revealed, to steadily dial down its US$120 billion monthly asset purchase program later this year. The closely watched Symposium is an annual event held for prominent central bankers, finance ministers, academic luminaries, and financial market leaders to discuss important issues that affect global financial markets.
The Fed has made several moves to support the US economy since the corona crisis began early last year. On 15 March 2020, the Fed cut short-term interest rates to zero, and in July 2020, it began its quantitative easing (QE) program, which has involved it purchasing $80 billion of Treasury securities and $40 billion of mortgage-backed securities (MBS) each month.
Both near-zero bound interest rates and QE are unconventional monetary policy mechanisms that have arguably been central to the US economy’s record-breaking performance over the past two years. They were last implemented in response to the 2008 Global Financial Crisis (GFC).
The Fed’s decision to begin tapering its QE program came as a surprise to some but remains in line with the central bank’s two monetary policy objectives: to achieve maximum employment and 2% average annual inflation rate over the long run. In a 2016 statement on longer-run goals, the Federal Open Market Committee (FOMC) clarifies that policy action directed at the average inflation rate target would only be considered “if inflation were running persistently above or below this objective”.
The employment report for July provided positive news on the maximum employment objective with 943,000 new jobs added and an unemployment rate that fell from 5.9% in June to 5.4% in July. While there is still some scope to increase US employment, the jobs market has recovered strongly and the Fed increasingly needs to be mindful it does not let inflation get out of control.
In light of achieving “clear progress” on employment, Powell is now turning to the economy’s surging inflation, which rose 5.3% through the year to July 2021 across all items for urban consumers. If we use the Fed’s preferred core inflation personal consumption expenditures (PCE) gauge that excludes volatile food and energy prices, then inflation rose 3.6% over the same time period. Whichever one you look at, both metrics have been tracking higher than the 2% inflation rate target since March this year (see Figure 1).
Figure 1. US CPI All Items and Core Inflation PCE, Seasonally Adjusted, annual change (%), July 20-21
By not acting on inflation now, the Fed is gambling that it can let the economy run hot and inflation higher than the 2% annual inflation rate target so that further strides toward maximum employment can be achieved.
Although the Fed has an obligation to keep inflation in check, US economic activity still appears to have a long way to go until it reaches pre-pandemic levels and therefore may still be in need of quantitative easing. There are currently 6 million (3.5%) more Americans out of work than before the pandemic and COVID-19 cases picked up again in July as the Delta strain sweeps across the nation and the rest of the world.
Despite inflation concerns, Senior fellow at the Peterson Institute for International Economics David Wilcox commented that with the “unusual combination of labour market dislocations and an inflationary impulse that looks unlikely to persist for the long-term… a central bank that pulls the trigger quickly on removing accommodation could be in the process of making a serious policy mistake”. A mismanaged and premature dialing down of quantitative easing, Wilcox argues, could have significant economic consequences.
Similarly, IMF Chief Economist Gita Gopinath has dubbed the Fed’s move a “taper tantrum”, referencing market hysteria in 2013 caused by former Fed Chair Ben Bananke’s announcement to reduce its 2008 GFC QE program. Investors, believing that the Fed’s withdrawal would cause the price of bonds to decline, responded immediately by offloading bonds that pushed down bond prices and increased bond yields (i.e. interest rates). The concern here is that Powell’s recent announcement may unsettle markets, causing a new “taper tantrum” and thus do more harm than good.
Gopinath and the IMF have also voiced apprehension about the effects of a premature tapering of QE on low to middle-income countries, which have suffered disproportionately from the coronavirus crisis. If inflation, which it believes to be driven by supply bottlenecks in different parts of the world, continues to rise, then “a much quicker normalisation of monetary policy in the US” will be required. In the event that emerging economies are hit with new waves of infections alongside a normalisation of monetary policy in the US (and hence higher interest rates worldwide), US$4.5 trillion could be erased from global GDP cumulatively by 2025, the IMF reported in a July blog post .
The severity of potential flow-on effects from a poorly timed reduction in the Fed’s asset purchasing program will be exacerbated by a substantial increase in average government debt across large economies, which rose from 52.2% of GDP before the pandemic to 60.5% in 2020 according to the Institute of International Finance.
That said, a reduction in the asset purchasing program may be necessary and desirable. Former US Treasury Secretary Lawrence Summers argued in a Bloomberg interview hours after the Jackson Hole symposium concluded that “inflation risks are graver than those that the chairman recognised”. The Fed, Summers says, should have started to move away from QE “some time ago” to avoid “toxic” side effects seen emerging in areas such as the housing market where prices have been rising rapidly.
In a similar vein, Senior Economist at BMO Capital Markets Sal Guatieri notes that “unpleasant side-effects” like inflation that usually take several years to emerge after a recession are emerging just a few quarters after the economy’s collapse. The “Fed’s temporary-inflation mantra is sounding more dated by the week”, and further steps should be taken to reduce QE to ensure the long-term stability of the US economy.
Ultimately, the Fed will have to continue playing a balancing game between its monetary policy objectives. If the Fed can manage to withdraw itself steadily and smoothly from financial markets, then Powell’s announcement may be a welcome sign of both US and global economic recovery from the corona crisis. The response from US stocks to the Fed’s plan seems positive for now, with US stocks surpassing old records this week, once again.
Published 1 September 2021. This article was prepared by Adept Economics Research Officer Ben Scott and Director Gene Tunny. Please get in touch with any questions via email@example.com or by calling us on +61 7 3085 7417.