Fed Dissent and Bond Volatility Are in Powell’s Taper Future

Jerome Powell doesn’t want to talk about scaling back massive Federal Reserve asset purchases -- at least not yet -- but it’s only a question of time before the discussion resumes and that might not be a bad thing.

The Fed chair told reporters on Jan. 27 that “the whole focus on exit is premature” -- a clear call to his colleagues to focus on the economic damage in front of them rather than the forecast for a recovery.

Even so, the world’s biggest bond market is trying to gauge when the U.S. central bank may alter its asset purchases, amid optimistic predictions that fiscal aid and vaccine rollout will boost the economy later this year. Powell’s effort to speak with one voice -- after some officials talked about the possibility of a 2021 taper -- risks muting other views within the central bank that could help make sure he gets policy right.

Fed Dissent and Bond Volatility Are in Powell’s Taper Future

“There is this difficulty and tension in how Fed officials are hoping this plays out,” says Matthew Luzzetti, chief U.S. economist at Deutsche Bank Securities.

Dallas Fed President Robert Kaplan said on Friday he expected “very enthusiastic debates” about scaling back asset purchases, though he declined to be drawn out on timing.

High Uncertainty

Talking about tapering the asset purchases now risks lifting financing costs right when the Fed is trying to stimulate the economy. But squelching diverse views may result in worse policy later. Economic inflection points are difficult to see, uncertainty is high, and in these moments a mix of opinions is important to good policy making.

“At some point it will make sense for them to discuss this, and I anticipate we will have diversity of views, even among Board members,” Luzzetti said.

Powell was at the Fed during the 2013 when plans to wind down stimulus spooked the bond market, roiled global stocks, and pushed up home borrowing costs in the U.S, leaving painful memories for U.S. central bankers.

Also, the ink is barely dry on the Fed’s December guidance, which said officials need to see “substantial further progress” on inflation and labor markets before tapering their $120 billion in monthly bond purchases. Powell last week also pointed to the more than 9 million Americans who are still unemployed and said that means the Fed is far from its employment goal.

But Wall Street banks are marking up their 2021 growth forecasts, with some seeing the unemployment rate dipping below 5% by year end. If that unfolds, it might be hard to argue that this isn’t “substantial further progress,” and Fed officials who are currently open to an earlier taper could become consensus leaders.

“They are on unfamiliar, unexplored terrain,” said Nathan Sheets, chief economist at PGIM Fixed Income. “It is going to require some pretty difficult judgments, and I do think various policy makers are going to see things differently.”

Investors say the risks from split messaging at the Fed are high given its impact on the near $21 trillion U.S. Treasury market, whose yields anchor over-$50 trillion in global dollar-denominated fixed-income securities.

Hawkish Impact

“Everyone at the FOMC has a little different take on things, and already we see it creating some speculation,” said Philip Marey, senior U.S. strategist at Rabobank. “The more hawkish people will have more of an impact than the dovish ones.”

While short-term yields are anchored by the Fed’s near zero policy rate, the 10-year Treasury yield surged above 1% last month to its highest since March amid fears the central bank could this year taper it’s bond buying. That sparked the widely watched 2-to-10 year curve to steepen to levels not seen since 2017.

The selling followed Democrats winning control of the Senate in early January, which boosted expectations for another government rescue package, and cautious comments from Fed officials who said the economy could be in for an upside surprise.

Atlantic Fed President Raphael Bostic called himself “open to the possibility” that asset purchases could be pared back sooner, based on efficient vaccine rollout and a pickup in growth.

FOMC Unity

Powell, who so far has suffered the fewest dissenting FOMC votes of any chair going back to Paul Volcker, is putting a lot of emphasis on speaking with one voice when they approach the time to taper.

“We understand that the way to do it is to communicate well in advance, to do predictable things and to move gradually,” he told reporters last week. “And that’s what we’re going to do. We’re going to be very transparent.”

Remaining unified might look like the best approach, but in practice it can hurt credibility in the long run.

As the Fed approached its first interest-rate increase in nearly a decade in 2015, three Fed governors had reservations – Powell, Lael Brainard and Daniel Tarullo. Powell managed his reluctance by penciling in fewer rate increases in 2016 than his colleagues.

Tarullo and Brainard weren’t enthusiastic about raising rates because they worried inflation would not sustainably rise to the Fed’s 2% target. But they both went along with the decision to raise rates from near zero, citing the way committee members had already telegraphed the hike.

“I don’t think it’s appropriate policy to raise rates today,” Tarullo said, according to transcripts of that December 2015 meeting, while acknowledging his vote was grudging: “The credibility of the FOMC is at some risk.”

In retrospect, the opposing governors turned out to be right. The FOMC failed to hit its inflation target consistently for the next four years. Dissents may have boosted the committee’s credibility by showing there was open debate over the decision to raise rates.

“They think the cost of dissent in terms of credibility outweighs the policy benefit they could get from different views,” said Derek Tang, an economist at LH Meyer, a policy analysis firm in Washington. “I think that is wrong.”

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