Bond sell-off fails to derail Fed unwinding plans for QE

US central bank appears unshaken by market turbulence and soft inflation readings

by: Sam Fleming in Washington

© Bloomberg

A sustained run of weak US inflation readings has yet to derail the Federal Reserve’s plans to start unwinding quantitative easing as soon as September.

The sensitivity of efforts to unwind crisis-era stimulus has been underscored in recent days as top officials in the euro area and the UK struggled to fine-tune their messages, triggering a bond-market sell-off. In the US core inflation retreated further on Friday, reinforcing calls from Fed critics for the central bank to shelve its tightening campaign.

But recent comments from US officials suggest they are sticking to their basic case that falling unemployment will eventually drive up price growth and that ultra-gradual tightening remains in order. Janet Yellen, the Fed chair, on Wednesday reiterated plans for gradual rate rises and said the Fed’s balance sheet plans were “well understood” by markets.

“They have effectively made their decisions on running down the balance sheet already, so they only need to decide when, and September is certainly possible,” said Roberto Perli, an economist at Cornerstone Macro. “Part of the motivation is to start the process this year before new leadership comes in in 2018. Meanwhile it is prudent to take a break from rate hikes to clarify what is happening on inflation.”

Minutes from the Fed’s latest policy meeting on Wednesday will shed more light on how the Federal Open Market Committee views sub-par inflation. Ms Yellen appeared sanguine about low price growth in June when the Fed lifted short-term interest rates by a quarter point, saying the process of shrinking the balance sheet could start “relatively soon”.

Patrick Harker, the Philadelphia Fed president, told the FT last month that he believed the Fed should hold fire on rates while moving forward with balance sheet rundown given his view — shared by many Fed policymakers — that the latter process will have only a modest tightening impact. This could point to a possible September move on the balance sheet with a rate rise on the cards in December, when policymakers will have a clearer sense of how inflation readings are panning out.

If inflation data were to disappoint persistently, or if the market sell-off were to gather steam, that would begin to shift more Fed officials towards a dovish stance. Some rate setters have cited the benign market conditions of recent months as a supportive factor to be balanced against soft inflation readings.

But it remains an article of faith among Fed rate-setters including Ms Yellen that once unemployment gets low enough it will trigger higher wages and inflation, arguing for a very gentle tightening in monetary policy.

The Fed has played down the significance of its balance sheet rundown, with Ms Yellen saying it will be as uneventful as watching paint dry, but that does not make the timing of the decision straightforward.

Leaving the kick-off as late as December, as some economists predict, could mean commencing a delicate process only seven weeks before the possible departure of Ms Yellen, who may not win a second term as Fed chair from President Donald Trump. Those weeks would be an anxious time in markets as investors anticipate a change of direction at the top of the Fed.

On the other hand, September, which is the other most likely moment to begin the balance sheet rundown, could be clouded by a debt ceiling showdown, something that would also prove destabilising to markets. The Congressional Budget Office last week said the Treasury may run out of cash in early- or mid-October if the debt limit is not lifted. The Fed’s next policy decisions are due on July 26 and September 20.

The Fed has to date been satisfied with the way the markets have digested its balance sheet communications, but it has bitter experience from 2013, when then-chair Ben Bernanke inadvertently triggered a bond market ‘tantrum’ by foreshadowing the tapering of bond purchases.

It is hard to know exactly how much of the Fed unwinding plan is already priced into markets. When the starting gun is fired, it will commence a process that would only be halted in the case of a nasty downturn. That could in itself mark an inflection point as traders are forced to adjust to a seemingly inexorable, multiyear process.

Mr Harker said in the FT interview that the decision on timing has yet to be made. With their favoured measure of core inflation now at just 1.4 per cent, Fed officials will be watching subpar inflation data closely and further disappointments would prompt doves to start calling for a change of view.

Policymakers will have three more consumer price index reports under their belt by the time they hold their September deliberations. Just as critical are employment readings, with the next jobs report due on Friday in the wake of a slowdown in business hiring over recent months.

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