The Big Idea

A step toward tapering, but more to go

| July 30, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

When the Fed looked at the economy at its July meeting, it saw progress toward the threshold for tapering. That puts tapering in play at any future FOMC meeting, including the next one in September. Next stop in the Fed’s advance notice process will be Chair Powell’s Jackson Hole speech.

FOMC statement

In addition to the pivotal addition to the FOMC statement that the economy “has made progress” toward the tapering threshold, there were several other tweaks that seemed surprisingly upbeat. Perhaps more importantly, one change did not occur. There was no allusion to the Delta variant or the recent wave in Covid cases and hospitalizations. The Fed has been incredibly cautious about the public health outlook throughout the pandemic, and the absence of any new expressions of caution or downside risk is a powerful clue that the thought process on the committee is shifting. In any case, here are the other important changes to the statement:

  • Sustained economic growth. This is simply a reflection of the passage of time. There was some shuffling of sentence structure at the top of the economic narrative paragraph, but the main change is that “indicators of economic activity and employment” went from “have strengthened” in June to “have continued to strengthen” in July.
  • Pandemic effects diminishing. “Sectors most adversely affected by the pandemic” went from “remain weak but have shown improvement” in June to “have shown improvement but have not fully recovered” in July. That is a clear upgrade in the assessment and accurately reflects the gains being seen in those sectors.
  • Inflation. Despite another month of blowout inflation, there was no change to the inflation description – “has risen, largely reflecting transitory factors.” Move along, nothing to see here.
  • Covid risks receding. In June, the statement noted that the “path of the economy will depend significantly on the course of the virus.” This time, the sentence was changed to “the path of the economy continues to depend on the course of the virus.” This is subtle, but the deletion of the word “significantly” is another sign, along with the lack of reference to the uptick in the virus, that the FOMC is giving less weight to public health downside risks in its economic outlook.

In sum, the handful of tweaks at the margin paint a consistent picture that the FOMC is gaining confidence in the economy and seems far less skittish about Covid risks than it has at any point in the pandemic.

The FOMC also announced that it is establishing a standing repo facility effective tomorrow. The minimum bid will be 25 bp with an aggregate daily limit of $500 billion. Treasuries, agencies and agency MBS will be eligible. To start, the counterparties will be primary dealers, but additional depository institutions will be added later.

Chair Powell press conference

Chair Powell in the opening statement of his press conference struck a more moderate tone than the changes in the statement implied regarding the evolution in the policy outlook. He noted that the economy is strengthening, as it bounces back from depressed levels. He characterized the consumer as robust, housing as “very strong,” and business investment as “solid.” He acknowledged production snags that have limited output in some sectors.

He admitted that the demand for labor is “very strong,” but then he reverted to the stale assessment that the unemployment rate is still high and understates the degree of weakness in the labor market. I would interject that when the unemployment rate is high because people are refusing to go back to work, this should be irrelevant to the Fed. Monetary policy can only influence the labor market by boosting demand, and, as Powell conceded, labor demand is already “very strong.” Powell and the FOMC are getting closer to the right answer but, for now, they remain stuck with a way of thinking that does not accurately pertain the current situation. In any case, Powell noted that the factors restraining labor supply should fade in the coming months.

On inflation, he did not utter the much‐maligned word “transitory.” He conceded that inflation will likely remain high in the coming months. However, as supply bottlenecks ease, inflation should cool. He remains confident that the surge in prices seen in recent months will prove more one‐off than persistent. However, he admitted that there is a risk that the restraints on production may continue to impede supply, extending the period of high inflation. It has been gradual, but we have seen a pretty dramatic evolution in the Fed’s near‐term inflation outlook over the past several months. In any case, he emphasized that inflation expectations are key. So far, he declared that expectations are still consistent with price stability.

On the virus, he noted that risks remain, and he mentioned the spread of the Delta variant and the uptick in new cases, a development that I thought might merit an allusion in the statement.

Finally, on forward guidance, he took a position that was far more qualified than the new sentence in the statement. He reported that the committee discussed the progress of the economy and reviewed various considerations today. The FOMC will continue to evaluate at each meeting, and their response will depend on the data. He also repeated that the FOMC will provide advance notice. Given the verb tense, we can conclude that the sentence added to the statement today has not already fulfilled that promise. When pressed in Q&A, he seemed to suggest that the “advance notice” commitment is more of a promise to be transparent throughout the process than a specific one‐off warning.

Under questioning, he laid out much more specific language regarding tapering. He noted that the labor market still has “some ground to cover” and is “some way away” from maximum employment. He did not offer specifics in terms of a numerical target for a particular indicator, but he did say that he wants to see a few strong jobs numbers. When pressed again later, he said that no decisions were made today on the timing of asset purchase reductions. He confirmed that he would be giving a speech at Jackson Hole, but he did not offer up any specifics on what he might say.

Later, he was asked about Treasuries vs. MBS in the tapering process. He said that he believes that Treasury and MBS purchases affect the economy similarly, so he does not see a compelling reason to treat them differently. He said that there was little support for tapering MBS earlier than Treasuries. There was more mixed opinion regarding whether MBS should be tapered faster. This will among the details that the Committee will have to debate and decide upon when it is time to taper. Finally, he fleshed out the Fed’s thinking with regard to the pandemic in response to a question. He noted with each successive wave of the pandemic, there have been less economic implications, as we have learned to live with COVID and to work around the constraints it imposes. Thus, he acknowledged that there could be some pullback in economic activity in response to the latest uptick, but he suggested that it probably would not be substantial. As always, the Fed will be monitoring the situation.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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