No Way Out Of This Rabbit Hole

No Way Out Of This Rabbit Hole

If you’re wondering what might stop the Fed from unveiling a taper over the next six months, the answer is “nothing.”

It’s almost impossible to imagine a macro scenario that pushes an unveil into 2022. Clearly, the combination of August’s lackluster jobs report and a cooler-than-expected read on inflation provide the Committee with more than enough plausible deniability when it comes to punting at the September meeting, but one way or another, the taper debate has a “now or never” feel to it. Either inflation takes off and you’re behind the curve, or it abates materially as the economy cools and then you’re tapering into disinflation.

I’ve long contended that policy normalization isn’t really possible, or at least not if by “normal” you mean a return to pre-financial crisis conditions. As we’ve seen in Japan and, increasingly, in Europe, the situation can become an intractable quagmire (see the figure on the right, below, from BofA).

There will always be an excuse to kick the can and while the pandemic may have changed the game when it comes to some of the myriad structural forces pushing down on inflation, it certainly didn’t eliminate all of them.

The point is simply that if the Fed doesn’t get moving on the taper soon, they may end up faced with the choice of tightening policy into a decelerating economy.

Peak growth is behind the US. That’s not to say the economy can’t sustain momentum or that outcomes won’t be robust, but you’d be naive to think that the odds of an overheat are materially greater than the odds of a disinflationary double-dip. I’d call it a coin toss.

With all of that said, the virus is a wild card. And, indeed, respondents to BofA’s September Fund Manager Survey said the Delta variant would be the most likely reason for a delayed taper (figure on the left, below).

Still, 84% expect a taper unveil by the end year, underscoring everything said above as well as the palpable sense of urgency among many officials.

While there’s doubtlessly a lot of truth to the notion that Fed officials inclined to “get moving” on the taper “sooner rather than later” are concerned about inflation (or, more likely, the perception among the public and lawmakers that the Fed is asleep at the wheel), I’d wager there’s also some worry that if the Fed doesn’t reduce the pace of monthly purchases fairly quickly, the Committee could face a daunting communications challenge in 2022 in the event the world’s largest economy loses momentum.

Recall that just last month, RBNZ was forced to delay a rate hike after Jacinda Ardern instituted a “snap” lockdown. Later, officials made it clear that the delay wasn’t due to any change in the economic outlook, but rather to the impossibility of explaining to the public why the central bank hiked rates on the very same day that the country went into lockdown.

That episode could end up being a microcosm of an eventual Fed dilemma if the taper doesn’t start relatively soon and the virus refuses to leave us all alone. I’ve called this the “Afghanistan” problem — there’s never a “good” time to tighten. Full normalization would probably lead to chaos.

Incidentally, one widely-followed “Finance Twitter” account last month suggested that tapering monthly bond-buying isn’t tightening. That was retweeted by several other popular personalities. Eventually, it landed in a recommended tweets email which elbowed its way into my regular inbox, even as I could swear I unsubscribed from Twitter email notifications. I’m not sure what kind of semantics or logic that person was using, but don’t be deluded. Of course tapering is tightening. Think about it this way: It’s not easing, is it?

Consider the figures (below) from SocGen’s Solomon Tadesse. The shadow rate has fallen nearly 800bps this cycle, with the majority of the easing impulse coming from QE.

“In the last two cycles, unconventional policies in the form of QE have contributed a large part of monetary easing,” Tadesse wrote, in a note out earlier this month. He added that,

In the post-GFC cycle of monetary easing, after three rounds of QE, forward guidance and other unconventional policies, the cumulative short rate fell by 850bps over an extended period of six years, bottoming out in November 2013. In the process, the QE measures accounted for about 62% of the total monetary easing during the cycle. Out of the total monetary easing provided in the ongoing post-pandemic monetary cycle (790bps), by our estimates, more than 65% could be attributed to the series of large-scale QE measures implemented in 2020.

It’s notoriously difficult to pin down a definitive, mathematical relationship between QE and equity prices. That’s more of a “me or your lyin’ eyes” exercise. But there’s academic literature on the shadow rate and the monetary policy stance. Indeed, as Tadesse noted, there are several versions of “empirical implementations.”

If that’s too academic for you (i.e., if you like anecdotes), just note that in this month’s BofA poll, 59% said monetary policy was “too simulative.” That, the bank’s Hartnett observed, was the most since May of 2011.

Little wonder folks are still overweight stocks.


11 thoughts on “No Way Out Of This Rabbit Hole

  1. If/when the Fed does taper, I expect that will result in an immediate sell off of stocks, similar to what happened last time we went to QT. Biden will start getting negative press for the stock market dipping (because Trump made it appear as if he controlled the stock market). With his approval raitng already hurting from the Afghanistan withdrawal and the 4th wave of Covid his CDC acted like was over, how long until he cans Powell? The SCOTUS ruling around FHFA could likely be extended to the Fed as well, that’s all the justification he needs to make the move. Then I expect the new chair would immediately re-commit to QE, putting us back on the IV drip. The rabbit hole keeps going and we find out just how strongly the world feels about USD as sovereign currency?

  2. “This Rabbit Hole” is one of many holes connected to a network of multiple holes and choices and outcomes.

    I was just reading an old Reuters story, apparently from 2019, called “Key events for the Fed in 2013: the year of the ‘taper tantrum'”, which gives some insight into concerns of the Fed between 2007 to the Tantrum and a long-string of meetings.

    I contend that an instantaneous knee-jerk reaction to unwinding, tapering or interpreting data, while we are in the midst of a pandemic is nothing less than stupid. The trump era trained people to think global economic changes were simply a matter of a mindless split second tweet blast.

    I get that the world is increasingly being run by kids that suffer from ADHA and various conditions that prevent connecting dots or making sense of complex data, but it seems like it’ll be risky to base economic choices like tapering on people who think economics is a playstation game.

  3. I’m reading some forecasts that Treasury will reduce bond issuance and MBS issuers will reduce issuance in 2022 by enough to offset expected tapering, resulting in “net” QE little changed.

    Can’t vouch for that, haven’t studied the numbers myself. I guess one might start on the funding charts on page 6 here

    https://home.treasury.gov/system/files/221/TBACCharge1Q32021.pdf

    as well as looking up the rate of new purchase mortgage issuance, which should presumably decline with sales volume.

    If FI participants believe the same, may explain muted effect of anticipated tapering on rates. And, via rates, on equities.

    Regardless, tapering precedes rate hikes – but by how much? given Fed’s insistent guidance that preconditions for the two differ widely.

    This is all happening at an altitude well higher than where I fly. Above my pay grade, as it were. But on general principles I am inclined to question the premise that because there was a taper tantrum last time, there will be one this time. The market likes to finds new ways to go awry. Rather than focusing too much on fighting the last war, best to look for other things that can go wrong.

  4. Modern economics tends to ignore biology. In the history of evolution on earth, it is not normal for a species to expand its range to cover the entire globe, to dramatically alter its environment, and to dominate the biosphere to the point where humans represent 36% of the biomass of all mammals on earth (and cows and pigs represent 60%). We underwent a massive change from hunter-gatherer bands to agrarian societies, to a largely urban existence, in the course of only about 10-20,000 years. Industrialization is yet more recent, representing perhaps only the last 150 years or so of history. Why do we think that economic concepts like debt and currency and interest and GDP will remain meaningful, or follow the same “rules” as they did 50 or 75 years ago, as human society continues to change? Even if these concepts maintain meaning as human expansion continues, will they retain the same meaning as humans reach the limits of unrestrained growth? Japan, Italy, and other mature societies are facing an end to economic growth as conventionally measured, an aging of the population, and a decline in overall population as birthrates drop. Why should conventional concepts of economic growth, of debt relationships, of investment and return, continue to apply as before? Even the concept of GDP and how it is conventionally measured is increasingly being challenged for its narrow focus and inability to account for quality of life factors and environmental sustainability. Why should we be surprised that our current set of economic descriptors, and our traditional set of fiscal and monetary policies, no longer function?

    1. Joey – great question. Great comment.

      Maybe we want/need theories to offer some kind of guideposts to try to make sense of random events. Even if the roads have changed.

    2. I understand your point but there is another way of looking at evolving outcomes, namely, that although the biosphere and the political economy have evolved, the changing outcomes could just be the result of different inputs to a stable system of relationships. Newton’s laws of motion, thermodynamics, optics, gravity, etc. have not suddenly evolved away, but the inputs they control have. BTW, I don’t know where you got your numbers showing that man, cows, and pigs make up 96% of all the mammalian biomass, but I doubt their validity.

      1. Lucky One – economics is a “soft science”, no? Many of the rules underpinning what we were taught were not based on some deep-rooted scientific laws, When did modern capitalism even emerge?

        Instead many economic rules were attempts by German economists to explain the Weimar inflation. That experience colored what came to be accepted economic gospel and was what our professors and then we were taught.

        To this day many in the academic world and market continue to cling to what they were taught. That economic framework is just too hard to toss aside, career-wise and personally.

        Sadly, central bank economists continued to cling to economic models derived from the Weimar experience far too long. Look how the German members of the ECB and the hard money governments insisted on prescribing castor oil & horse de-wormer after the 2008 financial crash. Oh sorry, I meant to type in “austerity”.

        Thankfully austerity appears to have been relegated to the historical curio file after the last hurrah proved disastrous.

    3. Economic and financial theory and practice will evolve.

      It is at best a soft science, anyway, where theories are devised to fit observations and applied to make money but can seldom be cleanly tested in a chaotic and reflexive environment. Negative rates will somehow get fit into finance theory, MMT into economics (maybe this has aheady been done, I dunno). Hedonics may come to GDP; you know governments would love it.

      For sure, when humanity is variously starving, drowning, heatstroking, sterilizing, and infanticiding itself in an uninhabitable 6 C world, economists’ prattle about inflation, riskfree rate, and NAIRU will be pretty irrelevant, if not an invitation to defenestration and cannibalism – if not immediately, then after the hedge fund managers have been digested .

      Until then, we’re here to invest and make money – not exclusively, but in a necessary-but-not-sufficient sense. As long as most market participants think an economic or financial measure or relationship is meaningful, it will have investment significance.

      1. jyl – spot on, once again.

        “It is at best a soft science, anyway, where theories are devised to fit observations and applied to make money but can seldom be cleanly tested in a chaotic and reflexive environment.” That’s the definition of APPLED ECOMONICS!

        I started my undergraduate studies in 1971. But even back then, I recall was horrified by the whole notion of “static equilibrium” which underpinned so many of the models we were taught and had to regurgitate in exams. Mostly USELESS in the real world.

        On the bright side, my early dismissal of the concept gave me a convenient excuse to focus more on young women and drinking than tedious study.

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