In addition to spotlighting the world’s greatest athletes, the Olympics often bring attention to obscure sports. Until 1920, the childhood classic rope game ‘tug of war’ was an Olympic competition. Today’s Olympics may not feature it, but the current Federal Reserve is fighting it.
A divided FOMC: hawks versus doves
One side of the FOMC is relatively dovish. This contingent comprises Fed Chair Powell, Lael Brainard and Richard Clarida. The other side, comprising regional Presidents Jim Bullard, Robert S. Kaplan, and Patrick T. Harker, is much more hawkish.
Our bias is to back the side with Chair Powell, whose influence is akin to having Dwayne ‘The Rock’ Johnson pulling rope on the team.
Today, the doves asserted their control as the Fed kept its statement largely unchanged and avoided offering formal guidance on tapering, underlining that while the committee is data dependent, it is also patient.
Delta variant adds to the doves’ case
The spread of the contagious delta variant has strengthened their argument, by exacerbating downside risks to the recovery. Although the vaccine rollout has dramatically reduced the probability of renewed large-scale restrictions, the variant has the potential to at least partially slow down the recovery, perhaps as a result of consumers voluntarily retrenching activity.
Ultimately, it makes the reason to begin withdrawing policy accommodation less compelling. Further, although the absolute pace of growth remains strong, economic activity has gone from consistently and substantially outperforming expectations, to slowing to consensus levels (Figure 1).
Figure 1: Economic data continues to be strong, but is no longer outperforming expectations1
We could even be at peak growth as a GDP growth rate of 8% to 10% is clearly unsustainable over the long run in the US. A gradual slowing is to be expected as the output gap narrows, adding further justification for policy caution.
No taper talk yet
The Fed made no formal communications around ‘tapering’ its asset purchases. While recognizing progress has been made since the start of the year, its statement retained the reference to “substantial further progress” being required before tapering could begin. Powell also noted the labor market is “some ways away” from hitting that benchmark, a dovish line in the sand.
As such, we continue to expect ‘taper talk’ at the Jackson Hole event in August. We see it as the ideal opportunity for Chairman Powell to lay out the Fed’s thinking and set the parameters of discussion on tapering, including whether to taper MBS purchases faster than Treasury purchases.
Alongside today’s policy announcement, the Fed announced a long-awaited standing repo facility to help ensure smooth functioning of money and Treasury markets. However, we do not view this announcement as impacting future monetary policy.
More tug of war rounds to come
The policy debate is far from over. We expect substantial further progress in the labor markets over the next few months, bringing unemployment down towards 4% to 4.5% by year-end. This may meet the Fed’s threshold to begin tapering.
As things stand, we believe tapering looks like a 2022 story, with the first rate hike potentially to follow in 2023.