Fed Is Buying Time, and That Makes Sense

The U.S. Federal Reserve is trying to buy itself time -- time to see if the current inflation spike subsides on its own, time to see if labor participation picks up, time to see how the economy performs with the fiscal stimulus boost fading, time to see if supply chain pressures ease. To do that, Fed Chair Jerome Powell has to walk a fine line: He can't sound ignorant of inflation's risk, but also wants enough flexibility to hold off on raising rates as long as possible. This buying time exercise is what Wednesday's Federal Open Market Committee meeting was all about. Let's see how they did. The Beginning of the End of QE As expected, the Fed announced that it will slow the pace of bond purchases. As previously telegraphed, the Fed will reduce overall bond purchases by $15 billion per month, currently $120 billion per month, with a $10 billion reduction in Treasury buys, currently $80 billion, and a $5 billion reduction in mortgage-backed security buys (currently $40 billion). This will start in November, implying it will be wrapped up by July. Two quick points on QE. The Fed is claiming they could speed up or slow down the pace of the tapering depending on economic conditions. I doubt it will speed up, but I would be shocked if it slowed down. The QE program is now doing more harm than good, as banks are so flush with reserves that their buying of money market securities is swamping the short-term bond market. If not for concern that it would send the wrong signal, the Fed probably would have started QE several months ago. Second, there's the question of whether the Fed will actually shrink the balance sheet once the tapering is complete. Powell was asked about this during the presser. Reality is the Fed is terrified of accidentally shrinking the balance sheet too much and causing bank reserves to become too scarce. Just last week there was a sudden dry up of liquidity in the rates and foreign exchange derivatives markets. That's the kind of thing that scares the Fed, and probably will prevent them from outright shrinking the balance sheet. Still Transitory? In the last few months, the Fed has described inflation as largely reflecting transitory factors. The Fed only made a minor tweak to this phrase, saying inflation is largely reflecting factors that are expected to be transitory. I'm not sure any part of this statement remains completely true. Transitory? With many companies indicating supply chain snarls will last well into 2022, it isn't feeling transitory anymore. What about largely reflecting? Many of the pandemic-related price surges have subsided, and yet inflation overall remains elevated. That's because inflation is becoming broader. In the last personal consumption expenditure inflation report, 68% of items rose at a 3% annualized rate or higher. That's the highest level for this measure since 2007. But what else is the Fed supposed to say? Going back to the idea of buying time, the Fed has to justify current inaction in some manner, while still assuring it won't let inflation get out of control. The only reasonable claim it can make is that current inflation will subside. Eventually this phrase too will seem stale, but for now I understand why they need to keep using transitory as a descriptor. Shifting Messaging on Jobs The Fed has been moving the goalposts on its employment goals for a couple months now. Earlier this year, Powell often cited recovering the vast majority of jobs that had been lost during the pandemic. But it has become increasingly clear that this recovery will take too long, primarily because labor supply is growing so slowly. The Fed rightly recognizes that monetary policy can't do anything about labor supply, and therefore needs to pivot on its employment goals. Powell hit this more head on in his prepared remarks. While he acknowledge that labor supply is a big challenge, he chalked it up to pandemic effects, namely child care difficulties and a general concern about catching COVID in a work setting. He argued that if the labor market remains hot, these people will eventually come back into the workforce. I like this framing as a communication strategy. It gives him a reason to still remain accommodative in the face of few people currently reentering the labor force. I'm skeptical that we are going to see a large rebound in labor force participation in the short-term. A Push-Back on Rates? Going into this meeting, we heard chatter among traders that the Fed might try to talk down interest rates. A lot has changed since the last time Powell gave a presser. The Fed funds futures market has gone from no hikes priced into 2023 to two hikes fully priced in for 2022. If the Fed were uncomfortable with what the market was projecting, perhaps it would do something forceful to push back, such as explicitly state that rate hikes were unlikely before 2023. I believe this idea is part of the reason why Treasury bonds rallied on Tuesday into early Wednesday morning. Powell had the chance to push back during the presser, when he was asked about two rate hikes currently priced into the Fed funds futures market. The Chair chose to neither endorse nor refute that pricing, instead saying that it was focused on the here and now. Later in answering a different question, he said that they needed to be in a position to act and that risk appears to be skewed to higher inflation. What this tells us is that Powell is open to hiking as soon as the middle of next year, or even sooner if the data supported such a move. I think that's the first time we've heard him acquiesce on that point. That doesn't mean he necessarily expects to hike that soon, but as he implied during the presser, he sees all the same inflation risk the rest of us do. Where Do Rates Go Now? The biggest question for Treasury rates now is not exactly when the Fed will start to hike, but how many times do it ultimately hikes during this cycle. If the Fed's target rate peaks at 1.75% or so, the 10-year is probably fairly priced at around 1.55%. But if the Fed gets to 2.5% or 3%, the 10-year is rich. So really what matters is how strong is the underlying economy, such that it can handle not only the end of fiscal stimulus, but also a series of rate hikes. I'm pretty optimistic on the economy, and therefore somewhat pessimistic on the bond market.

Fed Is Buying Time, and That Makes Sense

Here's why and how Powell is justifying the Fed's (lack of) action -- and why I'm optimistic on the economy, and pessimistic on the bond market.

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