What Fed Tapering Would Mean for the Markets and Economy

On Friday, Federal Reserve Chair Jerome Powell will give the opening remarks at the annual Jackson Hole Economic Symposium hosted by the Kansas City Fed. For several months it has been speculated that Powell might use this moment to announce a reduction in the pace of bond buying by the Fed, and recent ramping up of taper talk by various Fed officials have only fed this speculation. At this point it is a good bet that if tapering isn't overtly telegraphed in Friday's speech, it probably will be at the Fed's September meeting. So while we wait to hear from Jackson Hole, let's consider what quantitative easing (QE) tapering would mean for investment markets and the economy. QE Is Doing More Harm Than Good The surge in COVID cases related to the Delta variant has introduced a new angle of uncertainty into the economy. However, it will not deter the Fed from slowing QE buying. QE can have a few effects on the economy depending on circumstances. One obvious effect is that the Fed uses bank reserves to buy bonds, and hence QE creates new reserves out of thin air. In a world where banks are being constrained by a lack of reserves, this can help loosen monetary conditions. Nevertheless, this is not the case now. Banks are swimming in reserves, and every time the Fed pumps more into the system, banks try to rid themselves of the excess. We can see this via the massive subscriptions in the Fed's repo auctions. Another possible effect is related. In March 2020, when various market participants became desperate to convert bond holdings into immediate cash, it effectively created a run on market-making banks. The Fed used QE to alleviate that pressure and restore market making capacity. Obviously, we are in no such emergency now. Indeed, it is clear there is plenty of demand for longer-term bonds as witnessed by falling yields these last several weeks. If anything, QE is exacerbating the inadequate supply of longer-term bonds and thus holding yields down. The Fed knows QE is doing more harm than good. It is pumping more reserves into a banking system that already has more than it needs. It is draining supply of longer-term bonds at a time when demand is already hot. If not for the signaling effect of QE, the Fed would have tapered QE a long time ago. Separating QE From Mon Pol Of course, the signaling effect is still there. By that I mean investors are assuming that tapering QE is a form of monetary tightening. And why wouldn't they? Didn't the Fed tell us QE allowed them to make policy easier even after hitting the zero lower bound on rates? So wouldn't the opposite be true? That slowing QE means policy is less easy? I expect Powell will try to separate QE tapering from general monetary policy as part of his Jackson Hole address. Reality is that because commercial banks are flush with reserves and market making is normal, QE probably isn't having any effect on monetary policy. So in reality, tapering wouldn't have any practical effect. Powell will have to be careful, though. The Fed wants to retain optionality to claim QE has this easing property for the next time they hit the zero bound. I hope he is just straight with us, and says that QE's effects are probably conditional on the state of financial markets. He's avoided saying anything that blunt so far, though, so we'll see. Rate Hikes Might Be a Long Way Off It was a year ago at this same Jackson Hole conference that Powell announced the shift to Average Inflation Targeting (AIT). Expect him to remark on this anniversary and comment on the experience so far. He will probably also invoke AIT as part of the attempt to separate QE tapering from rate hikes. Indeed the AIT framework will make this communication much easier. He can say that while the substantial progress goal laid out for QE tapering has been reached, the overall goals of AIT have not, and therefore rate hikes are certainly not imminent. Hopefully, he goes on to emphasize that there is no particular time table: the timing of rate hikes should be entirely driven by the data. Rate hikes could come sooner, but they also could be years away. Market Reaction There may be little market reaction to this speech, even if he overtly telegraphs tapering. So many Fed officials have come out in favor of tapering sooner than later that the effect should be priced in by now. The next step will be to see how quickly the Fed decides to taper, but I doubt Powell would say anything that specific in his Jackson Hole address. Such a thing will have to wait for the formal announcement. The real volatility will come as the market prices in the timing of rate hikes. As I said last week, markets have become convinced that 2023 hikes will be a mistake, and that the U.S. economy is so fragile that even three to four rate hikes will torpedo growth. The market seems to be saying that current conditions in the U.S. are closer to the eurozone than they are to the pre-pandemic U.S. economy. That doesn't make much sense to me, and thus I'm inclined to think U.S. bond yields are too low. It will take several months of strong data to prove my thesis right or wrong, so if you take a defensive interest rate position, be sure you have staying power in case it takes a while.

What Fed Tapering Would Mean for the Markets and Economy

Ahead of Jackson Hole, the Fed knows QE is doing more harm than good.

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