The dangers of leaving it too late and losing the market's confidence are worse than those from cutting back the flow of quantitative easing. With a balance sheet of more than $7 trillion the risks of overdoing the tapering are relatively small.
A difference of opinion between the Fed's view of what it sees as transitory price gains and the market's assessment of the pricing of forward inflation expectations led to a sharp bond selloff in February. The Fed risks a repeat if it doesn't appear credible on inflation. If its more benign view is proved right - and inflation returns to close to the 2% Fed target next year - it can always modify its course.
The Fed isn't alone in this dilemma but it's the only one suffering institutional paranoia because of the 2013 taper tantrum. It needs to get over this: The levels of stimulus and the upswing in inflation were much lower then. The Bank of Canada has started tapering without any discernable impact on yields and the Bank of England will almost certainly end its QE program at the end of 2021. The grumblings from hawks on the European Central Bank's governing council are getting louder but it's in no shape to front run the Fed. Inflation is a collective global problem but where the U.S. goes the rest largely follow.
That's why it's important to recognize any subtle shifts in the Fed's view of whether the economic rebound will lead to an embedded shift in the inflationary environment. Vice Chair Richard Clarida noted last week that, "If we were to see upward pressure on prices or inflation that threatened to put inflation expectations higher, I've no doubt that we'd use our tools to address that situation."
Even Lael Brainard, a dovish member of the Federal Open Mark Committee, qualified her belief that long-term inflation expectations are well-anchored with the proviso that "we have the tools and the experience to gently guide inflation back to target" and that "no one should doubt our commitment to do so."
The Fed is still sticking by its central belief that most of the sharp inflation gains will fade next year. As a result, market fears of runaway inflation are subsiding even though central bank stimulus shows little sign of wavering.
But the prospect of inflation hasn't suddenly vanished. For the Fed to still be pumping in monthly stimulus of $120 billion creates big inflationary pressures, especially when set alongside U.S. growth this year that's forecast to exceed 6%. Consumer prices rose at an annual pace of 4.2% in April, with the more forward-looking producer price measure rising 6.2%. The release of the May CPI data on June 10 will be a major test of market confidence in the Fed's reassurances.
James Gorman, Morgan Stanley's boss, believes the Fed will start tapering at the end of this year and begin raising rates in early 2022. That might be too fast for the FOMC's current thinking but if inflation remains significantly above the 2% official target it may be hard to resist, especially if Joe Biden's administration continues with its multi-trillion dollar fiscal splurge.
Bond yields are probably heading higher over time, which is logical with the global economy recapturing lost ground from last year. The question is whether this will be an orderly process, with the Fed more in lockstep with the evident inflationary risks. Financial markets need to believe central bank modelling isn't divorced from the reality of supply bottlenecks, commodity price surges and a boom in retail sales. Time for central banks to start planning the orderly wind down of record stimulus. It'll be safer in the long run.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.
Published : May 27, 2021
By : Syndication Washington Post, Bloomberg Opinion · Marcus Ashworth