Tapering Here We Come?

The stock market could trade cautiously ahead of Fed Chair Powell's speech at the August 26-28 Kansas City Fed conference at Jackson Hole.  But, there is reason to think the recovery from the initial sell-off on the release of the July FOMC Minutes will continue.  

Initially, the market sold off on news headlines highlighting the Minutes' sentence that "many participants" could see the appropriateness of beginning to taper by year end.  But, a near-term start is not a given.  The news reports did not emphasize the conditionality of this view nor the lack of unanimity among the participants regarding the timing.   (One of the "hawks," Dallas Fed President Kaplan, already has said he may have to adjust his position on beginning tapering in October if the Delta variant significantly impacts the economy.)  Moreover, Biden's decision whether to re-appoint Powell as Fed Chair -- a decision expected to made this autumn -- conceivably could play a role in the timing of the tapering. 

There were 3 key sentences in the Minutes:

1. "Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee's 'substantial further progress' criterion as satisfied with respect to the price-stability goal and close to being satisfied with respect to the maximum-employment goal."

    a.  This is the sentence cited in news stories.

But, this was followed by sentences indicating differences of opinions among participants:

2. "Various participants commented that economic and financial conditions would likely warrant a reduction in coming months."

 3. "Several others indicated, however, that a reduction in the pace of asset purchases was more likely to become appropriate early next year because they saw prevailing conditions in the labor market as not being close to meeting the Committee's 'substantial further progress' standard or because of uncertainty about the degree of progress toward the price-stability goal." 

Given the lack of unanimity in the FOMC, Powell's speech is unlikely to be precise about when tapering will begin.   It could discuss the conditionality of the decision, but again not in a precise way (as he has done in is post-meeting news conferences).  He will probably emphasize the Fed's intent to maintain the funds rate at its currently low level for a long time.  Indeed, the need for a low interest rate as a catalyst to economic growth takes on more importance if tapering begins.  The markets' view of tapering could soften if this idea takes hold.  Stocks could have a relief rally after the speech.

Nevertheless, with the Claims data suggesting another strong Payroll gain in August, the next Employment Report will probably support the "hawks" at the September FOMC Meeting.   But, a large jobs gain may not be enough to satisfy the "doves."  They could still be concerned about the large shortfall in jobs relative to the pre-pandemic peak (5.7 Mn in July) and the 2% pt spread between the current Unemployment Rate and the pre-pandemic low (total as well as sub-groups).  The latter could be particularly important from a political perspective, given that Powell has committed the Fed to lowering the Unemployment Rate for Blacks and Hispanics.   So, while the September FOMC Statement will likely open the door for a tapering, it could leave the starting date dependent on further improvement in the labor market. 

The choice of the next Fed chair could influence the timing of tapering.  News reports suggest that Biden already is being pressured by progressive Democrats not to re-nominate Powell because he is not pushing the Fed hard enough in the direction of bank regulation, income inequality, and climate change.  Fed Governor Brainard is said to be the progressives' choice.  Biden may be forced to show his hand in September, since he could nominate Brainard for Fed Vice Chair, which will be vacant in October.  If Brainard is chosen to be Fed Chair instead, Powell could join the "doves" in pushing for a start to tapering in Q421, if only to make it easier for his successor.  If he is chosen, he could hold out against tapering until the Unemployment Rate spread shrinks by more -- avoiding a problem with Democrats in his confirmation hearings.

Besides the discussion on tapering, the FOMC Minutes contained an insightful summary of the Fed staff's economic outlook.  Fed staff said that "in the second half of 2021, an easing of the surge in demand seen over the first part of the year was expected to be largely offset by a reduction in the effects of supply constraints on production, thereby allowing real GDP growth to continue at a rapid pace."  Last week's US economic data fit this scenario -- July Retail Sales pointed to a flattening in their trend and housing data suggested a softening trend beginning in the 1-Family sector, but Industrial Production showed an upturn in the chip-constrained motor vehicle production.  This compositional shift has a curious implication for the inflation outlook -- slower demand will put downward pressure on prices, but so will an increase in supply as shortages ease.  The economy could be moving into a period of moderate, but uneven, growth and slowing inflation.  Ironically, this scenario could make it difficult for the Fed to justify tapering.