The central bank should start pulling back on its $120 billion monthly bond purchases and signal when it will lift rates, but it probably won’t.
It has been only 17 months since the biggest unthinkable in the oil market - the price turning negative - illustrated vividly that the global economy was experiencing an unprecedented shock that required an exceptional policy response by the government and the Federal Reserve. This week, Fed policy makers will discuss how to unwind two of its three chief components over time.
The oil unthinkable was the result of the collapse in demand that accompanied the first stages of the 2020 Covid-19 economic shock. Stranded by storage facilities that were either full or extremely expensive, holders of oil scrambled to liquidate their excess supply, with some even willing to pay buyers to take it off their hands.
The dominant general theme at that time, that of deficient demand relative to available supply, was not new. It had dogged policy makers since the 2008 global financial crisis, albeit much less extreme but more generalized. It had led central banks to run extremely loose financial monetary policies characterized by unusually low interest rates, huge injections of liquidity through large-scale asset purchases and aggressively loose forward policy guidance. Indeed, what the Fed did in 2020, while remarkable in size and scope, actually built on a decade of extraordinary monetary policy.
Today, the macroeconomic landscape is much different.
The household and corporate sectors — in aggregate though not every member — have strong balance sheets having benefited from ample fiscal transfers and subsidized debt refinancings. Demand and sentiment remain solid.
The only thing blocking an even bigger demand boom is the Covid delta variant, and even that is not strong enough to hold back retail sales, as last week’s upside data surprise illustrated.
That alone is enough reason for the Fed to detail this week how and when it intends to withdraw two of the emergency measures that are still in place more than a year after the worse of the Covid economic and financial shock. The central bank should announce the immediate initiation of a tapering of quantitative easing with a goal of eliminating the $120 billion of monthly purchases in the first half of next year; and it should signal through its forward policy guidance a gradual lifting of near-zero interest rates starting in the second half of next year.
But while deficient aggregate demand is no longer a problem, the supply side is and will remain so for a while. As detailed here, what ails supply chains, transportation and worker availability goes well beyond temporary and quickly reversible factors. Longer-term structural forces are also in play, raising the specter of inflation that remains higher and more persistent than the Fed has repeatedly forecast until now.
That, too, suggests that the Fed should start gradually easing its foot off its pedal-to-the-metal QE and signal its intention to tap the brakes down the road in an orderly fashion via higher interest rates. This would be best done if, on its side, Congress were to open the door for fast progress on the Biden administration’s infrastructure plan, physical and human, and if financial regulators were to coordinate better, nationally and internationally, to strengthen prudential policies, especially as they pertain to dampening excessive risk-taking among nonbank market participants.
Yet the Fed is unlikely to do so this week for several reasons, from the inability to embrace sufficiently yet the extent to which the demand and supply paradigm has shifted to concerns about triggering a disorderly correction of elevated asset prices after the excessive risk-taking encouraged by years of ample and predictable liquidity injections.
Rather than proceed with a taper now and signal the initiation next year of a measured and gradual normalization of interest rates, the Fed is likely to adopt a more dovish approach. This could include signaling the possible start of a taper later this year or early next year, reiterating that the taper decision is decoupled from the policy rate decision, signaling a delayed and slower interest rate normalization and packaging all of this in highly conditional language.
I suspect that most market participants, including long-term investors, would much prefer this course of action to the alternative, which I believe is necessary and feasible. “QE infinity” remains their top policy choice for the Fed given the extent to which central bank liquidity has turbocharged asset valuations, allowing for such a historical decoupling from underlying economic fundamentals.
Yet as appealing as this seems, it would be rather shortsighted because it would allow economic and financial risks to continue to rise unduly, threatening the long-term inclusive recovery needed not just for sustainable economic well-being but also for underpinning genuine financial stability. Indeed, by the time the Fed finds itself forced to hit the brakes, the window for doing so in an orderly fashion may prove worrisomely tight.