September 10, 2021
With each additional tidbit of data economists and market participants reevaluate the timing and speed with which the Fed will “taper” its monthly purchases of securities. It is true, that reducing its securities purchases represents the beginning of a change in the direction of monetary policy from an extremely “accommodative” stance to something that is more “neutral”. But what the markets should be concerned about is that point in time when the Fed actually raises short-term interest rates in an effort to slow the pace of economic activity and/or reduce the rate of inflation. But Fed officials have been quick to point out that rate hikes are not on the horizon until at least 2023. The slow, gradual tapering process will have no discernable impact on the pace of economic activity, and should raise long-term interest rates only slightly. While such action could trigger some sort of short-term stock market “correction”, the reality is that still robust GDP growth, a moderate pick up in the inflation rate, and a Fed pledge to maintain low rates far into the future will continue to produce solid growth in corporate earnings and drive the stock market steadily upwards.
Lowering the funds rate to essentially 0% and purchasing securities were emergency measures taken – appropriately so – during the course of the recession in March and April 2020.
Currently the Fed purchases $120 billion of a combination of U.S. Treasury and mortgage backed securities each month. By so doing, it steadily increases its balance sheet and, therefore, its policy becomes progressively more accommodative.
This means that in September 2021 the Fed still has its foot on the accelerator despite 6.6% GDP growth in the second quarter, robust GDP growth likely for the third quarter (we currently expect 8.0% growth), and a core inflation rate that has climbed to 4.2% and is seemingly headed higher. It is time for the Fed to revert to a somewhat more neutral policy stance.
Most economists expect the Fed to gradually reduce its monthly purchases of securities from $120 billion per month beginning in January of next year to $0 by December. This is the first step in shifting policy back to neutral. But even in December 2022 the Fed will still have a 0% funds rate. Its policy will remain highly accommodative. So what would constitute a “neutral” funds rate? To answer that question we tend to look at the “real” or inflation-adjusted funds rate.
Today the funds rate is essentially 0%. The year-over-year increase in the CPI is 5.3%. Thus, the real funds rate is -5.3%. But over the past 20 years, the real funds rate has averaged -0.5%. This means that, on average, during periods when the Fed has both eased and tightened, the funds rate has averaged 0.5% lower than the inflation rate. We would suggest that constitutes a “neutral” real funds rate. If the Fed is correct and the recent run-up in inflation returns to 2.0% next year, then a “neutral” funds rate should be about 0.5% less than that or 1.5%. But 0.0% is not 1.5%. Fed policy will remain highly accommodative long after the Fed stops purchasing government securities.
The Fed suggests that anticipates two rate hikes in 2023 which would lift the funds rate to 0.6%. But 0.6% is also not 1.5%. Fed policy is likely to remain in accommodative mood through the end of 2023. And with a presidential election looming in November 2024 you can bet that the Fed is not going to push rates much higher even in that year. This is September 2021. We are speculating about something that might, or might not happen, three years from now. That makes no sense. For now, we should plan on Fed policy remaining highly accommodative through the end of 2023. So quit fretting about when and how rapidly the Fed is going to reduce its purchases of government securities matters little. That is small potatoes.
There are lots more important things to worry about:
- Will COVID cases continue to climb? Or are they once again beginning to slow? We think they are slowing.
- How many workers will return to their jobs now that the federal unemployment benefits have ended. We expect employment gains to average 700 thousand per month between now and yearend.
- Will the runup in inflation prove to be temporary? We think it will be elevated for a lot longer period of time than the Fed expects with the core CPI rising 5.1% this year and 3.7% in 2022 – not the 2.0% pace that the Fed anticipates.
Stephen Slifer
NumberNomics
Charleston, S.C.
HI Steve,
If we get the 700k employment gains as economist predict, would that cause wage inflation which would accelerate the feds timeline on buybacks and change the funds rate outlook next year?
Hi Mike,
Nice to hear from you. I see you are now with Stifel. I just did a presentation to them in Columbia, SC just a couple of months ago. Good group.
Yes, I suspect 700T increases in employment will tend to boost wage pressures. We are already beginning to see it. Average hourly earnings have risen 4.3% in the past year, but at a 5.6% pace in the past three months, so the wages of all those restaurant workers and Walmart workers we hear about are beginning to show through. And I think those higher wages, as well as higher commodity prices, are boosting the CPI.
In the past year the core CPI has risen 4.2% but in the past three months it has picked up to a 7.8% pace. Then the PPI that we got this morning for August had exactly the same pattern — steadily increasing inflation. Thus, the Fed’s story that all of this pickup in inflation is temporary is wearing thin. For what it is worth, I am looking for the core CPI to increase 5.1% this year and 3.7% in 2022. The Fed is looking for 3.0% this year and 2.0% in 2022.
Having said all that, do I think the Fed is going to raise rates in 2022? Absolutely not. What they should do is irrelevant. They seem determined to gradually phase out their monthly bond purchases in 2022, but not raise rates — almost under any circumstances — until 2023. The other thing to keep in mind is that we have an election in November of next year. And Powell seems to be the most politically influenced Fed Chair I have come across in my career. He is not going to raise rates right ahead of an important election when control of one or both houses of Congress are at stake.
Hope all is well on your end.
Steve