“Inflation could be a lot more persistent than we had hoped.”
By Wolf Richter for WOLF STREET.
Right after the Fed ends its asset purchases in the first half next year, the Fed should start reducing the assets on its balance sheet by letting maturing bonds roll off without replacement, said St. Louis Fed president James Bullard, a monetary-policy dove who will rotate into a voting slot next year, in an interview with Reuters.
“Everything can occur much faster than it could have in the previous recovery,” he said, pointing at economic output that already exceeds pre-pandemic levels.
“We should start to allow runoff of the balance sheet,” he said. “We could get going on that process at the end of the taper” next year. “That would be a natural time to do it.”
This is the first time in this cycle that a Fed official put a time stamp on when the asset reduction – the QE unwind – should start. Fed Chair Jerome Powell had previously said that the Fed would eventually do this, and everyone brushed him off, but now Bullard wants to see this happen starting about mid-2022 before the Fed even begins to raise short-term rates.
During the last QE-unwind, the Fed – after it had started raising short-term rates – reduced its assets by 15%, from $4.45 trillion in November 2017 to $3.76 trillion in September 2019. Mortgage rates hit 5% in November 2018, stocks fell, and in September 2019, the repo market started blowing out.
This time around, the Fed would be better prepared to deal with markets going haywire because in July it implemented the Standing Repo Facilities for repos and reverse repos, which it had before the Financial Crisis but replaced with QE. This time around, with the SRF in place, the Fed wouldn’t need to come up with ad-hoc solutions.
Bullard didn’t specifically say this, but a reduction in assets on the balance sheet would allow long-term yields and mortgage rates to rise. With the short-term rates still initially locked into place by the Fed, the yield curve would steepen, which would be a good thing, and would allow the Fed to then raise short-term policy rates without flattening the yield curve.
Bullard has for months been fretting about the “threatening housing bubble” the Fed is fueling with its massive purchases of mortgage-backed securities.
He said he expects inflation, as measured by the lowest lowball inflation measure, core PCE, to still be at 2.8% by the end of 2022, well above the Fed’s target of 2.0%. Core PCE most recently hit 3.6%, the highest since 1991.
While inflation may ease somewhat, it will take more effort by the Fed to ensure that happens smoothly over time, and never requires the sort of restrictive policies that could imperil the current expansion, he told Reuters.
Inflation, he said, “is going to stay above target over the forecast horizon. That is a good thing. We are delivering on our…framework.” This new framework calls for inflation to run above 2% for a while to make up for the years it ran below 2%, as measured by the lowest lowball inflation measure, core PCE.
“There is now a risk we are going to overachieve and be too high for too long,” he said. “How much of that do we want? That is the key question for the Committee over the next year.”
The exact start date and pace of tapering of the asset purchases hasn’t been announced in the FOMC statement yet, but will likely happen at the next meeting on November 3. Fed governors have come out and supported a start of tapering in November and be done with it in the first half – at which point, no new bonds would be added and only maturing bonds would be replaced, which would keep the Fed’s assets flat. That would be the completion of tapering.
It would likely take a “very large shock” to throw the process of tapering off course, Bullard told Reuters.
Bullard proposed today to start the next step – the actual reduction of assets on the balance sheet – right then and there.
The assets on the Fed’s balance sheet would be around $8.5 trillion by the time the Fed stops adding to them, and Bullard told Reuters that there was no reason to hold on to them.
The FOMC has not yet begun those discussions, he told Reuters, but “I don’t think it is too early” given the surprising speed of the recovery and the concern about inflation.
Even if long-term Treasury yields rise steeply next year, they will likely remain below the rate of CPI inflation, and therefore “real” Treasury yields would remain negative, which would still provide a highly stimulative fuel in the most grotesquely overstimulated economy ever.
In terms of short-term interest rates, Bullard said he sees two rate hikes in 2022, on concerns over the global supply shock and above-target inflation becoming anchored. Over time, he sees short-term rates slightly above 2%, with inflation back to about 2%, which he estimates would be about neutral (neither stimulative nor restrictive).
But with the assets on the Fed’s balance sheet being reduced, long-term rates would theoretically meander higher, removing stimulus off where it really matters – long-term borrowing costs.
It may all work out “and we will converge into bliss at the steady state where inflation is at 2% and we never change the funds rate again,” he told Reuters. “That is the current scenario,” he said. But “we all know reality will probably be something messier,” he said. And “inflation could also be a lot more persistent than we had hoped, and in that case, we will have to recalibrate how we are going to keep inflation under control.”
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