Joe confirms QE tapering, but veils it with artful dovishness

Fed Chair Jerome Powell’s Jackson Hole speech was a balanced outline on the economy even as it confirmed the advent of QE tapering before the end of 2021. The confirmation is a stepup from FOMC’s last meeting, where several members had expressed the need for early tapering.

On the progress towards Fed’s objectives of greater than 2% inflation and maximum employment, the expressions were far emphatic than earlier; he confirmed that conditions of “substantial further progress” towards meeting these goals have been met.

Hence, even as high core inflation spikes (headline inflation at 4.2%, core PCE at 3.6% & core CPI at 4.2% Jun’21) are seen contributed significantly by transitory factors, with the rise sharper than Fed’s expectations and future moderation expected to be gradual, tapering will still be justified.

Strong jobs data for July suggest further strengthening of the labour market. The slack in the labour market exists, as reflected in the fact that 6 million people are still seeking jobs and the unemployment rate is at 5.4%. But the pace of decline and large number of job openings are expected to cover the slack quickly. With 10 million job openings, there are 1.6 job openings for every unemployed person. Speedy vaccination (and end of dole out checks) should see more people re-joining work, which should also help ease supply bottlenecks. Enhanced vaccination drive should minimise risks arising from spread of the new delta variant.

Shortest shock & quickest rebound
Several indicators were cited to highlight that the pandemic-led recession was the shortest and rebound was the sharpest, notwithstanding the uneven growth recovery thus far. The recovery in consumption has been robust and it now exceeds the pre-pandemic level by 7% and pre-pandemic trend by 4%; Durable consumption has rebounded 32% higher than the pre pandemic level!!

The Balancing Act
Powell used empirical evidences from the past to make sure his communication was not hawkish. It was an artful mix combining the intent to initiate normalisation but still sound dovish.

So what were the dovish elements? First, it was made clear that QE tapering does not mean abandonment of an accommodative stance. Second, tapering should not be extrapolated to suggest rate lift off. Third, several pieces of evidence were cited to show that recent inflation spikes were due to transitory factors. High inflation is seen primarily driven by clustering of demand for goods away from services amid supply chain bottlenecks; there are early signs of easing of supply constraints. Also that spikes are concentrated in select items like durables, second hand vehicles etc, which have shown negative or very moderate inflation in the past. Fourth, evidences from 1950-1990 show that premature withdrawal of accommodative policy in response to transient spikes in inflation can harm the economy. But evidence from 1970s also suggests that core inflation can continue to rise even after the transient elements fade. Given these uncertainties, a careful monitoring of incoming data will be crucial in determining the future path.

Our View
Powell could not have been more explicit in confirming early QE tapering. Considering his communications till the Jackson Hole speech today, Fed appears to have given enough prior intimation to the markets. There are three meetings from now till the end of 2021 (September 21-22, November 2-3, and December 14-15). We think there is a reasonable chance of tapering starting between September-November 21.

While incremental data will surely be considered, having outlined the future course of action there is little chance of dithery. Based on recent history of normalisation, the monthly moderation could be $15-20 billion from the current purchase program of $120 billion per month. Following eight months of tapering, Fed’s balance sheet may still be running down along with eventual rate lift-off by end 2022.

Next year US fiscal deficit is estimated to decline by $1.8 trillion, largely due to expiration of the $1.9 trillion American Rescue Plan leading to $1.3 trillion reduction in spending budget. Hence, the need for the Fed to monetise US treasuries will diminish significantly.

In a constructive scenario, US money supply (M2) to GDP is expected to decline gradually from 89% currently to 80% by the end of 2024. As a result, money multiplier (M2/base money) and velocity of money (nominal GDP/M2) are expected to rise over time. Overall, with US leading the global normalisation process, US dollar will sustain a strengthening bias. From EM equity perspective, effective communication by the Fed should ensure orderly market conditions. But it is also likely that excess liquidity-driven multiple expansion thus far will also dissipate.

Dhanajay Sinha is MD &
Chief Strategist at JM Financial Institutional Securities. Views are his own.)

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