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

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 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.