Fed Remains in a Tough Spot
This is not the situation that we have faced for a very long time and it is one in which there is a tension between our two objectives…Inflation is high and well above target and yet there appears to be slack in the labor market,
The just-released BLS Economic Situation noted the U.S. created 194K new jobs in September 2021 compared to the consensus view of 490K. Even though the counts for August and July were revised up by 38K and 131K, respectively, this still leaves the economy with five million fewer jobs than the pre-pandemic level in February 2020.
The unemployment rate fell to 4.8 percent in September, but the labor force participation rate, at 61.6 percent, is still 1.7 percent point lower than in February 2020. The number of unemployed people stands at 7.7 million, higher than the February 2020 level of 5.7 million. The employment to population ratio, at 58.7 percent, is also below the February 2020 level of 61.1 percent.
All considered the latest jobs report continues to indicate slack in the economy, making Fed’s job difficult as the inflation continues to run hot (see Fig. 1).
The inflation may be showing signs of peaking, but the supply chain constraints – a significant contributor to inflation – are not abating. These supply chain bottlenecks are slowing down the global economy, and the GDP forecasts made just a few months ago looked too rosy and needed to be downgraded.
Significant Downgrades of Q3 GDP Forecasts
Calculated Risk reports that the Wall Street analysts have been downgrading their Q3 US GDP forecast for the past few months. Experts are blaming the Delta variant of the Coronavirus and the supply chain disruptions for the downgrade. BofA Merrill Lynch reduced its Q3 forecast from 7.0% at the end of July 2021 to 2.0% in the first week of October 2021, Goldman Sachs lowered its forecast from 9.0% to 3.25% over the same period, and the Atlanta Fed’s GDNOW stands at 1.3% compared to 6.1% on July 30, 2021.
The slowing down of the economy throws another wrench in the Fed’s monetary policy works.
To Taper or Not to Taper That is the Question
The economy added close to 200K jobs in September, not a trifling number, but whether this number is decent or not is something experts will debate in the coming days. The label is important because Chair Powell said last month that he is looking for a “decent” jobs report before the central bank starts easing the accommodative monetary policies, aka start tapering. Already, economists are saying that there is a decent case that this jobs report is not decent enough to taper.
The economists on the other side say that the market is sending the Fed clear signals to taper. The U.S. government bond traders also want the Fed to stop buying Treasuries, hoping that it will create better trading opportunities for them.
Reading the tea leaves left behind by the market and the Fed, we believe that the chances that the Fed will start to taper in November are pretty high. Even though the economy may be stalling, it has recovered considerably and does not seem to need any more accommodative monetary policy. The market is also separating tapering from the rate increases.
To Raise Rates or Not To Raise Rates May Not Be the Question
Central banks around the world are getting jittery of rising inflation. Some still believe that it is transitory, but many have developed serious concerns and have started to raise rates even in surprise moves, and some are even hinting of more tightening to come. Some central banks have been implementing aggressive monetary policies for a while.
Naturally, the pressure is also building on the Fed, and there is a growing chance that it may raise rates earlier than previously expected. Even so, this may not happen before the middle of 2022. The probability of the Fed raising rates by then is still low, and some 60% of economists polled by the National Association for Business Economics expect the Fed to hold rates at zero through 2022. The Fed’s Summary of Economic Projections released in September shows that nine members of FOMC – half of its participants – expect the Fed to raise rates in 2022. Only seven members predicted such a rise in June’s projections. All but one member expect the rates to rise in 2023. None is expecting the rates to rise in 2021.
Fed’s Last Attempt Led to A Taper Tantrum
The last time Fed tapered its accommodative bond-buying program, initiated in response to the 2007-2009 Great Recession, was in 2013. That year was a tumultuous one for the Federal Reserve and the U.S. economy.
The Unemployment stood at 7.9 percentage and the Fed’s preferred inflation gauge, Personal Consumption Expenditures (PCE), was at 1.7 percent when the FOMC held its January 2013 policy meeting. At the time, the newly minted member of the Fed Board of Governors, Jerome Powell, wanted to taper bond purchases and end them before the year-end. Ben Bernanke, the Fed Chair at the time, first revealed his thoughts on taper – that it would depend upon continued improvement – in May 2013 to the general public.
After a year’s debate, the Fed decided to start tapering in its December 2013 meeting by reducing its monthly pace of asset purchase to $75 billion from $85 billion. By that time, the Unemployment Rate had declined to a 5-year low of 6.9 percent, and the PCE inflation was at 1.6 percent – about the same as at the January 2013 meeting.
The taper began in the first week of 2014, the stock market barely broke a sweat (see Fig. 2), but the bonds were not so lucky. The 30-Year U.S. Treasury Yield had a wild ride circa 2009-2011 before its down move in February 2011 (see Fig. 3). It bottomed in July 2012 when the murmurs of a fed taper program started. It picked steam in November 2012 and in April 2013 when supportive news came out of FOMC. However, the yield peaked a week before the Fed started its taper in January 2014.
Last Time Fed Started To Raise Rates, Stocks and Bonds Behaved Differently
The Fed cut its Fed Funds rate to zero in December 2008 and started a Zero-Rate-Policy or ZIRP that lasted for the next seven years. The Fed raised rates for the first time after adopting ZIRP in December 2015, almost two years after it started to taper the bond-purchase program.
The stocks had plateaued in early 2015 before the first rate hike and then moved within a Horizontal Channel for almost two years (see Fig. 2). Part of this was due to rate hikes, and part of it was due to the austerity measures enacted by the U.S. Congress as part of Budget Sequestration.
Bonds behaved differently. Treasury yields fell for a year after the start of the taper (see Fig. 3). In early 2015 they recovered some ground but then were again falling by the December 2015 rate hike. It was not before July 2016 that the yields started to rise.
Are There Any Parallels to The Present?
History may not repeat, but it rhymes, especially in the financial markets. One reason for that is that similar events elicit similar responses from people if the environment is comparable. And, we can list many analogous happenings now compared to circa 2013.
The Fed hasn’t announced any taper though the rumblings of it have increased. There is a reasonable probability that it may announce the taper in November with a start date in December 2021. The comparable timeframe in the past would be the late Fall of 2013. At that time, the up-trending stocks were experiencing a minor retracement. Today, the stocks are in an up-trend and are pulling back a bit from the highs (see Fig. 4).
In late Fall 2013, the 30-year U.S. Treasury yield had just retraced from a high level and was in the process of resuming the uptrend. This time around, too, the yield has retraced from a high and is turning up again (see Fig. 5)
In the U.S. Congress, a drama is being unfolded regarding the debt ceiling just like it did then. The Fed members and the markets are hinting rate hike around mid-2023, about the same time as the taper announcement to rate hike last time.
Equities continued to rise for at least another year following the start of the taper in January 2014. They hit a Horizontal Channel by the end of 2014. Noticeably, they did not turn down and went into a bear market. Bond yields hit highs in the week preceding the start of the taper and then declined for another year. The chances of that happening again are considerable.
Essentially, the market did not show any signs of concern in 2013. An equivalent outcome may likely occur this time too.