Powell and Federal Reserve under pressure to manage exit from ultra-simple policy

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Federal Reserve Chairman Jerome Powell testifies at a US House Oversight and Reform Select Subcommittee hearing on the coronavirus crisis, on Capitol Hill in Washington, June 22, 2021.
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It was hard enough for the Federal Reserve to conduct the easiest monetary policy in the institution’s history. Going out won’t be a treat either.

That’s what the central bank will face on its way.

Investors will hear more on Friday about what Fed chairman Jerome Powell thinks about the economy. They also expect to get at least a few more clues about how he will guide the central bank in exiting the measures it has taken to save the country’s economy from the Covid-19 pandemic. He will deliver a speech in conjunction with the Fed’s annual Jackson Hole conference, which will again be held virtually this year.

The first on the Fed’s list is: withdraw from printing money — the roughly $120 billion in bonds it buys each month to boost demand and lower long-term interest rates.

Then the road gets rougher.

At some point, the Fed will attempt to raise short-term interest rates from the near-zero anchor they have been in since March 2020. so from 2015-18, as it had to stop mid-cycle amid a slumping economy.

Therefore, the markets can be excused for being at least a little nervous this time around. Not only does the Fed need to reverse its most aggressive easing policy ever, it also needs to do it with precision and hope it doesn’t violate anything.

“Any Fed change in monetary policy is important,” said Priya Misra, head of rates strategy at TD Securities. “But I think it makes more sense today because we know growth is slowing and the Fed is trying to get out.”

Indeed, the economy is still well into a strong recovery from the depths of the pandemic, which steepest but shortest recession in US history. But the rebound seemed to at least come to a halt. The Citi Economic Surprise Index, which measures actual data against Wall Street estimates, reached an all-time high in mid-July. But the index has now fallen to levels last seen in June 2020.

Fed officials themselves expect noticeably slower growth in the coming years at a time when both monetary and fiscal policies will be tighter. That raises more questions about whether Powell and his cohorts can get the exit right.

“Are they going out in the right place? Are they coming out at the right time, in the right size? Given the slowdown in the economy, we have questions about both,” Misra said. “The market is pricing in a policy error.”

What Misra means by a policy flaw is that current pricing in fed funds futures — the market that trades around the Fed’s interest rate movements — indicates that the Fed’s central bank can only raise its interest rates a few times to maybe $1. 25%. Then it will have to stop when growth stagnates.

Rates that deter Fed officials because they give them little leeway to ease policy in times of crisis. That was roughly where fund rates stood at the start of the pandemic crisis, falling significantly from the target range of 2.25%-2.5% where the Fed completed its latest rate hike cycle in December 2018.

The calculus for how to manage all this will fall to Powell from a communications standpoint, and to the other members of the Federal Open Market Committee in terms of actual mechanics.

“Tapering is important because it is a very good measure of not only the credibility of the Fed, but also communication, how good the strategy is and how transparent it is,” said Deepak Puri, chief investment officer for America at Deutsche Bank. wealth. Management. “In 2013, the Fed made mistakes in its communication about tapering.”

That 2013 episode — the so-called Taper Tantrum as it’s now known — is the only template the market has for how the Fed might move forward.

Misra, the TD Securities strategist, pointed out that the Fed is already showing that it has learned a lesson from the earlier episode, because it is now phasing out the market. The 2013 proclamation of then-Fed Chair Ben Bernanke was considered abrupt and caused interest rates to soar and stocks to fall for several months before those trends reversed.

“They’re doing well in the sense that they’re really trying not to surprise the markets. That prevents a mistake they made in 2013. That’s positive,” said Shawn Snyder, chief of investment strategy at Citi US Consumer Wealth Management. . “They are in a bit of a difficult situation, because the delta variant acts as a wild card.”

The Fed and the markets have been on their hips for a long time, but especially in the era of quantitative easing and zero interest rates that began in 2008. increase bond purchases.

During the initial run-down, the market eventually recovered its losses, even after the run-down began and through the rate hike cycle – until late 2018, when a series of communications missteps by Powell rocked investors.


Nourished balance sheet, stock market rising

As the Federal Reserve built up its balance sheet, the S&P 500 index bounced back

of the Covid crash to reach record levels

Total Assets of the Federal Reserve

Note: shaded area represents recession in the US. The Fed’s balance sheet data has not been adjusted.

Source: Board of Governors of the Federal Reserve System, via Federal Reserve Bank of St. Louis

(assets), FactSet (S&P 500). Data as of August 18, 2021.

As the Federal Reserve built up its balance

leaf, the S&P 500 index bounced back

of the Covid crash to reach record levels

Total Assets of the Federal Reserve

Note: shaded area represents recession in the US. fed

balance sheet data has not been adjusted.

Source: Federal Reserve Board of Governors

System, through Federal Reserve Bank of St. Louis

(assets), FactSet (S&P 500). Data as of 18-8-21.

Nourished balance sheet, stock market rising

As the Federal Reserve built up its balance sheet, the S&P 500 index

bounced back from the Covid crash to reach record levels

Total Assets of the Federal Reserve

Note: shaded area represents recession in the US. The Fed’s balance sheet data has not been adjusted.

Source: Board of Governors of the Federal Reserve System, via Federal Reserve

Bank of St. Louis (assets), FactSet (S&P 500). Data as of August 18, 2021.

On the economic side, Fed officials have placed less emphasis on their policies and more on fiscal aid and the path of the virus.

The Covid strain casts doubt on where the growth is headed. But several regional Fed presidents speaking to CNBC this week said the virus appears to have little impact on growth and is not weighing on their economic forecasts for now.

“Consumers and businesses are becoming more flexible and resilient, and I think people expect that [the virus] will come in fits and starts,” said Robert Kaplan, president of the Dallas Fed, one of the proponents of a speedy, albeit slow, repeal of the policy.

The informal consensus in the market right now is that the Fed will begin to wind down before the end of the year, completing the process in eight to 10 months. After that, it will evaluate where things stand before talking about rates.

Complicating matters for Powell are some sensitive political dynamics, both inside and outside the Fed.

The emerging aggressive tendency of regional presidents such as Kaplan and James Bullard at the St. Louis Fed clashes with more moderate members such as Governor Lael Brainard and San Francisco Fed President Mary Daly.

In addition, Powell is up for reappointment in February, as are several other Fed officials, and President Joe Biden has yet to announce his affiliations. Powell already knows what it’s like to lean on keeping interest rates low after his experience with former President Donald Trump, but he’ll still have to herd cats to some degree to keep a Fed consensus together as the shifting economic and pandemic conditions.

An image of US President Joe Biden is broadcast on a screen after his speech to the nation on the situation in Afghanistan as traders work on the trading floor of the New York Stock Exchange (NYSE) in Manhattan, New York City, US, August 17 , 2021.

Andrew Kelly | Reuters

“The concern for both the Fed and the economy is the danger of applying political pressure to get the desired results across the political spectrum, undermining the independence of the Fed,” said Charles Plosser, the former president of the Fed. Philadelphia Fed, to CNBC in a broadcast interview. . “Powell is in a delicate place.”

For his part, Powell used his 2020 Jackson Hole speech to outline a dramatic shift in policy regarding the Fed’s view of inflation. The new framework reflects the desire to achieve full and inclusive employment, even if that means high inflation, and the policy has been blamed in some quarters for the price hikes this year.

“We are in a period where monetary and fiscal policy is at the most stimulative level we have seen in 75 years,” Plosser said. “They need to ask what role policy plays in making this inflation more intractable than it would otherwise turn out to be.”

Powell’s speech on Friday is not expected to deliver such major breakthroughs in the Fed’s approach, but will instead focus on current and future expected conditions with a small hint of how he and his fellow policymakers will try to make sense of all this. to manage.

But it will likely pave the way for how the central bank goes back to normal, so the pressure will still be high.

“The real question for me is what happens next year,” said Snyder, the Citi strategist. “Do we find ourselves looking at moderating the economy and moderating inflation that will make it difficult for the Fed to raise interest rates? … I think people are very concerned about the idea that this may not work working as we planned.”

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