The Federal Reserve’s (Fed) plans for tapering its asset purchases have become increasingly clear over the past two weeks. Fed Chair Jerome Powell’s speech today at Jackson Hole, together with last week’s release of the minutes from the July policy meeting, provided a number of details from which the Fed’s base case can be inferred with a reasonable amount of clarity.
The Federal Open Market Committee (FOMC) July meeting minutes said that most committee members considered the inflation criteria to have been met. And while the employment criteria had not yet been met as of July, most committee members expected that it would be met in subsequent months. In his speech today, Chair Powell said that he broadly shared the committee’s assessment with regard to its criteria. Chair Powell did mention the additional month of strong data that has been released in the meantime, while also sounding slightly more concerned about the economic impacts of the Covid delta variant. This likely just reflects the news since the July meeting rather than a difference between Powell and the committee, or a change in policy plans.
While the decision to taper purchases is primarily a reflection of the economic conditions, there are at least two other considerations that are likely affecting the timing of tapering asset purchases. The first has been Powell’s commitment to provide “advance notice” ahead of a final announcement. In our view, neither the July minutes nor Powell’s speech likely rise to the standard of “advance notice.” (In contrast to the general acknowledgement of economic progress that has characterized recent communications, we expect the “advance notice” to be something rather explicit, such as saying that tapering could be announced at a “coming meeting.”) The lack of advance notice means that a final tapering announcement is at least a meeting away and therefore is unlikely to happen in September.
The second consideration is that the process of scaling back policy accommodation tends to have some inertia to it. This means that once the scaling back process has started, and that includes the communication about scaling back, it tends to continue—albeit at varying speeds depending on the circumstances, until either action is taken or a significant event throws the plans off course.
One reason for the inertia, perhaps particularly relevant today, is that it can help leadership manage diverging views on the committee. As we know from recent public comments, many Fed officials have been advocating for a faster taper, with a number even pushing for a September announcement. On the other side, there are at least a few Fed officials who remain concerned about the inflation outlook for next year and the unevenness of the labor market recovery. These officials have cautioned about the risks of withdrawing accommodation prematurely. Chair Powell said today that he shares the concerns of this latter group. In particular, Powell warned that an “ill-timed” removal of accommodation could have harmful effects on employment and inflation. Regardless of his personal views, Powell is the leader of the committee and he cannot entirely ignore the dissenting views. It’s entirely possible that Fed leadership has forged something of a compromise by pushing back on the hawkish calls for a September announcement, while at the same time promising that progress is being made and the taper is getting closer. What to insiders might be a compromise between the leadership and a minority may at the same time appear to outsiders as inertial policymaking.
Another reason for the policy inertia has to do with the fact that recoveries are inherently gradual. There is rarely a sharp turn in data or events to explicitly signal that the time has arrived to scale back. In the absence of a sharp signal, policymakers naturally resort to simple heuristics to guide their actions. One such heuristic may be to use the calendar as a guide. This could be behind the desire to start the process “this year.” Of course, there is nothing special about something that starts in December 2021 versus something that starts in January 2022, but aiming for something “this year” may make it feel more tangible and therefore more achievable.
It has been reported that in 2015 Stanley Fischer, who was at the time the Fed Vice Chair, consistently pushed the committee toward an initial rate hike by the end of that year, even though inflation and growth data flagged in the fourth quarter. While we don’t know for sure, and we may never know, it’s possible that Vice Chair Richard Clarida is now playing a similar role on the committee. Vice Chair Clarida said in January that he expected the Fed to taper “this year.” It’s perhaps not a coincidence that he’s stuck to that line ever since, even in the face of surprises in the economic data, surprises in fiscal policy and more recently surprises regarding Covid. Adhering to a simple timeline of “this year” is a practical way to make decisions that could easily be overcomplicated if one attempted to follow a more sophisticated decision-making framework.
Adding all of this together—both the economic conditions and the softer considerations around scaling back accommodation—leaves us with the following picture of the Fed’s base case, at least as it stands currently. At the September meeting the Fed likely plans to provide “advance notice” by saying that tapering will be announced at a “coming meeting”; then in either November or December the Fed likely plans to announce a decision to taper purchases; and then, finally, the Fed likely plans to reduce asset purchases in the month following the final announcement.
Policy Inertia: Advantages and Disadvantages
Providing a clear picture of the taper timeline has likely been the intent of recent Fed communications. All year the Fed has erred on the side of overcommunicating about tapering, which has generated the sense of apparent inertia in the policy process. Officials have provided multiple forewarnings and signposts along the way, and they have made it very clear that an eventual taper was more than just a possibility, indeed it has been their plan. This communication strategy has likely been motivated by a desire to avoid a repeat of the “taper tantrum” in 2013. Keeping taper firmly on the agenda can help to limit any buildup of expectations and positions that would need to be subsequently unwound, thereby helping to reduce the market volatility associated with the actual announcement.
This type of strategy has both advantages and disadvantages. The advantage is that the final taper announcement is unlikely to surprise anybody when it actually happens. As a result, there is unlikely to be much market volatility due to the announcement itself. Limiting market volatility is not explicitly part of the Fed’s objectives, but it is a consideration that appears to be at least somewhat important to Fed officials. Limiting volatility may be especially important to Fed officials during recovery periods because shocks to either interest rates or risk sentiment would likely work against their broader goals at the time.
There are disadvantages as well. The main one is that policy inertia tends to limit the Fed’s flexibility in the last few months before the action is expected. This could be true in the current context. After so many comments by Fed officials about tapering “this year,” a decision to adjust that timeline, even if it were only to delay slightly into next year, would be given a disproportionate amount of import. The concern that a small change would send an unintentionally large signal may make it harder for the Fed to adjust appropriately to a slight downgrade in the outlook.
To be clear, Fed officials have not given up all of their flexibility with regard to their taper plans. There appears to be some optionality built into the Fed’s base case, as either a November or a December final announcement could reasonably be considered “this year.” The Fed also has a number of other levers that could modify the impact of the taper announcement, such as the pace and composition of the taper, not to mention signals about rate policy that it could send simultaneously. And there should be no doubt that if the outlook were to change meaningfully, then Fed officials would find a way to overcome the inertia and change policy as well. All of those conversations are for another day, however, as the main intent currently is to communicate about the taper plan that exists, rather than to modify it. For the time being, this inertia in the policy process seems to have taken over, for better or worse.