Taper Talk Has Arrived, Rates Remain Subdued

FS Insight Team

The continued prevalence of high inflation numbers has the Fed in a bit of an awkward position, and on the periphery of the FOMC rumblings have begun about tapering. It appears the long foretold ‘thinking about, thinking about’ tapering has finally begun. However, the core position of the Fed and actions so far remain in the accommodative stance and likely will for the immediate future. There is definitely a tidal shift in the discourse though and the Fed appears to know it.

The headline inflation number that came in hot a few weeks ago was headline grabbing but it also had several characteristics under the hood that allowed the Fed to credibly dismiss the alarm bell some Fed skeptics and former candidates for Fed chair have been raising. That number is also not one the Fed uses for its purposes. However, the indicator that the Fed considers the best indicator with regards to measuring inflation has just risen at a faster than expected pace of 3.1%. Now, this is still within the bounds of the AIT framework and the core of the FOMC is standing strong, but this is a significant development that this indicator is also coming hot, although much less so than the other number. The expectation was for a reading of 2.9%.

Dallas Federal Reserve Bank President Robert Kaplan said on Thursday that he wants to talk with his colleagues about tapering. “I think it would be wise sooner rather than later to begin gently taking our foot off the accelerator, so we can avoid and reduce the probability of having to apply the brakes down the road,” the Fed President said on CNBC. While this sentiment is certainly not universally shared by the Fed, in the sometimes glacial and ultra-nuanced progression of the modern Fed it is nonetheless a significant development, and it appears to be gaining traction based on the recently released minutes we discussed in these pages last week.

The political pressure is mounting on the Fed. Judy Shelton penned an opinion piece in the WSJ about how the Fed lacks the appropriate tools to deal with runaway inflation. Senate Minority Mitch McConnell is also a huge Larry Summers fan all of the sudden, citing his recent public opinions on inflation risk. Even if the Fed is convinced that inflation is primarily transitory and it very well may be, it will still likely have to step up messaging to counter the growing public skepticism.

The Fed’s balance sheet has now reached approximately 40% of GDP, so there are multiple angles that merit healthy scrutiny without devolving into hardline Fed skepticism. Also, US households are now very sensitive to the impact of monetary policy and the so called ‘wealth effect’, when consumers spend more as their wealth grows, could cut pretty negatively in the event of a severe correction in asset prices which we don’t anticipate, but which is always a mere black swan event away. The debt side of the picture is even more complicated. The ballooning government debt has now gotten to such prodigious levels that tightening itself could prove counterproductive in certain situations due to the crowding out that could occur from increasing debt service payments if rates rise too fast. Same with equities. This is what is meant when people speculate that the “Fed is in a box.”

Asset purchases continued at a pace of $40 billion a month for MBS and $80 billion a month for Treasuries. The benchmark yield on the 10 year is a pretty tame 1.58%.

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