ADVERTISEMENT

Fed Sets a Date With Bond Vigilantes in Eight Months

Fed Sets a Date With Bond Vigilantes in Eight Months

Eight months. That’s how long Federal Reserve Chair Jerome Powell and his fellow policy makers have given themselves to keep the bond vigilantes at bay.

The U.S. central bank announced Wednesday that it would begin tapering its $120 billion of monthly bond purchases starting later in November in an acknowledgment that the American economy has made “substantial further progress” toward the Fed’s employment and inflation goals. It will scale back by $15 billion a month — $10 billion in Treasuries and $5 billion in mortgage-backed securities. That’s in line with consensus estimates across Wall Street and positions the Fed to no longer provide accommodation through asset purchases by mid-2022.

Fed Sets a Date With Bond Vigilantes in Eight Months

You have to hand it to the Federal Open Market Committee: Policy makers successfully held off on tapering until the bond market was practically begging for it, and officials were unanimous in taking action. The U.S. central bank did not directly cause the bond-market carnage among hedge funds in recent weeks — rather, its counterparts in Australia, Canada and the U.K. sparked the fire sales in front-end rates. By comparison, moves in Treasuries have seemed outright orderly. 

Still, Fed officials can’t afford to take a victory lap. In many ways, the next several months will be the trickiest yet for the central bank’s grand experiment with inflation and its new policy framework. 

For one, it would take repeated huge economic data surprises for the Fed to adjust its pace of scaling back asset purchases, which it acknowledged it could do if warranted. This is crucial because Powell has said in no uncertain terms that the central bank wouldn’t consider raising interest rates while still buying any amount of bonds. That means from now through mid-2022, the Fed doesn’t have a policy lever to pull if inflation remains elevated. That scenario is different from the one for the Bank of Canada, which ended quantitative easing last month and opened the door for a rate increase as early as January if necessary (though Bloomberg Economics expects the first one will come in July).

This is all by design for the Fed. Remember, the central bank’s new enhanced forward guidance states three conditions for when it would be appropriate to raise interest rates from near zero:

  1. When “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”
  2. When “inflation has risen to 2 percent.” 

  3. When inflation also “is on track to moderately exceed 2 percent for some time.” 

The U.S. economy is obviously well past point No. 2. More Fed officials, even Powell, have acknowledged that price pressures are likely to remain elevated. Among Powell’s  final remarks before the central bank’s self-imposed blackout period: “The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation.” But he was quick to add: “I do think it’s time to taper, and I don’t think it’s time to raise rates.”

That distinction is because of point No. 1. Sure, the U.S. quits rate is at the highest level on record, job openings are higher than at any point in history, and a broad gauge of wages and benefits just had its largest jump ever. These are all signs of a tight labor market. Still, Fed officials made no secret earlier this year that they were looking at the employment-to-population ratio as an indication of when the economy has returned to its pre-pandemic strength.

Fed Sets a Date With Bond Vigilantes in Eight Months

At 58.7%, “EPOP” remains more than 2 percentage points below its February 2020 level. In the past eight months, it has increased 1.2 percentage points. It’s certainly possible that the gauge will rise more quickly in the coming months. But if the labor market heals at its current pace during the tapering period, it would still fall short of a full rebound to pre-pandemic levels.

“We’re aware that language sounds a little out of touch with what’s going on,” Powell said during his press conference, referring to the three conditions for interest-rate increases. “But we’re not at maximum employment. When that is the case, we’ll look to see whether the inflation test is met, and there’s a good chance that it will be, if you look at how inflation has evolved in the last year and a half.”

That brings the analysis back to inflation. Powell took a starkly one-sided view during his much-anticipated Jackson Hole speech, delivering a full-throated defense of the central bank’s position that it would ultimately prove to be a transitory phenomenon. Much of his argument hasn’t held up in recent months. Tim Duy, chief U.S. economist at SGH Macro Advisors, pointed to the Dallas Fed’s trimmed PCE number as a sign that price pressures are more broad than just used cars, and to the aforementioned employment cost index as pushing back on Powell’s claim that “today we see little evidence of wage increases that might threaten excessive inflation.”

Notably, the Fed’s policy statement leaned hard into supply-chain constraints as the cause of elevated inflation. It added a line that “supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.” Still, that’s “expected to be transitory.”

“The level of inflation we have right now is not at all consistent with price stability,” Powell said. “We’re also not at maximum employment. I would want to assure people that we will use our tools as appropriate to get inflation under control. We don’t think it’s a good time to raise interest rates, though, because we want to see the labor market heal further.”

If inflation doesn’t revert toward 2% and remains elevated for the next eight months, however, bond traders will undoubtedly try to bully the Fed into a rate increase next July, even if the U.S. hasn’t reached maximum employment by some measures. Jan Hatzius and other economists at Goldman Sachs Group Inc. are already forecasting such a move, aligning themselves with the short-term rates markets. 

For now, Treasuries are taking the taper in stride. The benchmark 10-year yield rose by about 3 basis points after the Fed’s decision, to 1.59%, and the two-year yield was little changed at 0.48%, down 8 basis points from its intraday high last week. Real inflation-adjusted yields remain about as negative as ever.

But make no mistake: Today’s taper timeline gives bond vigilantes a set date on when to pounce if Powell is wrong about inflation. They won’t be as intimidating as they were when James Carville made his famous quote about debt markets in the 1990s, but in this new era of monetary policy, any sort of move higher from the zero lower bound is a big deal.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

©2021 Bloomberg L.P.