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2.02.2021 61

Why we don’t expect the Fed to taper its bond buying programme this year

Published February 2, 2021

5 to 10 minutes

5 to 10 minutes

SUMMARY


In a world where sovereign bond yields are in the hand of central banks, the recent upward revisions of growth expectations for the US economy raised questions about the outlook for the Fed’s monetary policy. Growth is expected to rebound in H2 and very accommodative monetary policy is not a free lunch. The difficulty for the Fed is estimating how sustainable this expected improvement in growth and inflation will be in H2 2021. We expect the Fed to keep a cautious approach and we believe tapering is more likely in 2022 when the core PCE index will have made significant progress towards the objective of a sustainable increase to an average of 2% or higher.

 

Commentary from two regional Fed presidents, Robert Kaplan (Dallas) and Raphael Bostic (Atlanta), has led to market speculation that the Fed might reduce its bond purchases sooner than anticipated. In response, members of the Governing Council sought to allay any concerns that the Fed may soon taper its bond purchase programme. What is our view?

We agree that the Fed will need at some point to reduce the pace of its asset purchases


We expect the US economy to rebound strongly in H2 2021. The economy is likely to accelerate next spring, as herd immunisation will allow the reopening of the consumer services that account for most of the remaining output gap. In addition, this recovery will be supported by three other factors. (1) The new Biden administration is clearly inclined to maintain significant government support. Janet Yellen, the new Treasury secretary, voiced strong support for Joe Biden’s $1.9tn relief package, arguing that “with interest at historical lows, the smartest thing we can do is act big”. (2) The pandemic has resulted in record US savings rates, but mostly for households with the highest incomes. This should fuel a midyear consumption boom and support asset valuations. (3) The Fed will maintain an accommodative monetary policy. Changes to the Fed’s policy framework will likely allow the economy to operate longer at lower interest rates. Base effects will be strong: we will see inflation temporarily overshooting the 2% target as well as a rapid improvement in the labour market.
However, a very accommodative monetary policy is not a free lunch: low borrowing costs could contribute to asset bubbles, overreliance by companies and households on cheap debt and growing inequalities. The Covid-19 crisis has accelerated the already existing fragmentation of the US economy. The damage caused by this crisis is disproportionately concentrated on certain industry groups and small businesses. Indeed, large companies in specific sectors like technology and healthcare have outperformed in recent years and have not suffered from the crisis. The US is currently a two-speed economy.

  • Small companies, lower quality issuers and cyclical sectors should show more balance sheet discipline. These businesses have accumulated debt due to the decline in economic activity and are now more leverage-constrained. Keeping rates low is necessary to facilitate deleveraging of these companies.
  • On the other hand, companies in the tech sector could be encouraged by the central bank’s new framework to take on more debt as the economic climate improves. Undeniably, despite the crisis, these sectors have seen a jump in their M&A activities and asset valuations. At some stage, the Fed may start to worry about financial conditions being too accommodative for this segment of the economy, leading to excesses.

The Federal Reserve’s general view is that financial risks are manageable at the moment, notwithstanding “some issues” related to high levels of corporate debt and elevated pricing for commercial real estate.

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A difficult task


The difficulty for the Fed is estimating how sustainable the expected improvement in growth and inflation will be in H2 2021. This is not an easy assessment for two reasons. First, most of the factors supporting the expected rebound in growth in the second half of 2021 will be temporary by nature. Second, the huge upcoming budget support makes the exercise even more difficult. The strategic question is whether this huge fiscal spending will help to increase the potential growth of the US economy. If it does, the US economy will be able to absorb a rise in interest rates. Otherwise, the US economy will simply need more support from the Fed to guarantee accommodative financing conditions despite high government deficit!
No room for mistakes: the US economy is highly sensitive to a rise in interest rates. The crisis has been characterised by very successful coordinated action by governments and central banks to limit the long-term damage to our economies. Central bank liquidity injections combined with government debt guarantees have kept funding conditions accommodative despite the historical contraction in GDP. However, we will emerge from this crisis with a much higher level of debt and high asset prices. As a result, a small upward move in interest rates today would have a bigger impact than in past cycles on corporate debt, the equity market and real estate markets.
The market’s reaction is key! The Fed is committed to maintaining accommodative financing conditions: rates should rise for good reasons! The key question for investors is why interest rates are rising. Rising rates are positive for markets if they are expanding because of a sustainable improvement in real growth. Rising rates are negative for markets if they are expanding because of excess supply amid lower support from central banks. Clearly, the Fed would welcome higher yields without a tightening of financial conditions. This is exactly what has happened in recent weeks and it has confirmed the credibility of its monetary policy.

We have to make significant progress towards that goal. This does not necessarily mean that we have to get to that point. 

Raphael Bostic

Now is not the time to be talking about exit. I think that is another lesson of the global financial crisis, is be careful not to exit too early.

Jerome Powell

We expect the Fed to keep a cautious approach


The forward guidance attached to the QE is very vague and leaves the Fed a lot of flexibility. Asset purchases should remain in place “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals”.
No pre-emptive tightening with the new policy framework. The Fed is committed to an inflation overshoot under its new Flexible Average Inflation Targeting (FAIT) regime. The Fed’s new reaction function implies that some inflation must be evident before raising rates, rather than simply forecasting it to rise. The FOMC will aim to push unemployment as low as possible, at least until inflation pressures appear. The maximum employment objective is “a broad-based and inclusive goal”.
We believe tapering is more likely in 2022 when the core PCE index will have made significant progress towards the objective of a sustainable rise to 2% or higher. We do not expect the Fed to pre-emptively taper its accommodative policy. Inflation is expected to temporarily rise above 2% in Q2 2021 due to significant base effects, but the Fed will have to see sustainable progress in the underlying inflation trend before tapering, which is more likely in 2022. We do not expect supply to be a driver for rates. We expect higher rates because of an improvement in growth/inflation forecasts.

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