Substantial Further Progress? Not Yet, Says the Fed
The statement and press conference following the July U.S. Federal Open Market Committee (FOMC) meeting reinforced PIMCO’s outlook that in the second half of this year, the FOMC will announce it plans to begin to wind down its large-scale asset purchases. Indeed, the July FOMC meeting statement acknowledged that progress has been made toward the committee’s inflation and maximum employment goals, but stopped short of calling it substantial. Nevertheless, the FOMC also indicated its plans to continue to assess this progress “in coming meetings.”
We think these statement changes leave open the possibility that the Fed could announce the first reduction in the pace of its bond purchases as early as September, but reaffirmed our view that December is the most likely timing for any announcement. In his post-meeting press conference, Fed Chair Jerome Powell confirmed that the FOMC still intends to give “advance notice” ahead of any decision, while stating that the labor market still had some “ground to cover” before substantial progress is achieved.
In any case, the statement and press conference confirmed that the FOMC had an in-depth discussion on the outlook for the large-scale asset purchase programs (LSAPs). In particular, we think these discussions likely encompassed three key questions, which we expect the Fed to answer in the weeks and months ahead: When should tapering begin? What is the optimal plan and schedule for diminishing purchases (e.g., should mortgage purchases be tapered earlier or faster than U.S. Treasuries)? And how will the Fed communicate its tapering plans in an effort to alleviate market volatility?
In what follows, we discuss our views on the “when,” “what,” and “how” questions.
When to taper?
On the timing of any tapering announcement, the Fed has said it will continue the current pace of asset purchases “until substantial further progress” is made toward its dual mandate on price stability and employment. Depending on the FOMC’s interpretation, we think this goal could be met as early as September, but more likely December.
On the price stability side of the mandate, there is no question that U.S. inflation has made substantial progress. U.S. Core CPI (consumer price index) inflation, for example, jumped to 4.5% (year-over-year) in June – overshooting the Fed’s target. However, because the sources of the strength in inflation were either the categories suffering from acute supply constraints (new and used vehicles and auto rentals), some of which may already be easing somewhat, or categories that suffered the largest declines as a result of social mobility restrictions (airfares and hotels), the June CPI report likely didn’t change the narrative that the recent inflation spike is just that: a transitory spike. Furthermore, despite the acceleration in realized inflation, longer-term inflation expectations still appear aligned with the Fed’s longer-term 2% target.
Where there is more room for discussion is around what “substantial further progress” means for the U.S. labor market. We see two questions: First, has the level of maximum employment changed since the pandemic? And second, how small does the remaining gap between actual employment and maximum employment need to be before Fed policymakers are comfortable with announcing tapering?
Maximum employment is a highly uncertain moving target. Every year, positive population growth contributes to labor supply and increases the level of maximum employment. A strong labor market can also increase the level of maximum employment, while notable economic shocks (recessions, productivity booms, import competition, etc.) may also have a significant impact.
In our view, maximum employment probably declined as a result of the pandemic. We see several reasons for this:
- The pandemic has been a catalyst to a wave of retirements – by our calculations, based on Bureau of Labor Statistics data, around 25% of the decline in employment during the pandemic has been due to retirements.
- A pickup in migration from individuals and households able to work remotely could be reducing overall job matching efficiency. For example, the influx of people now living and working remotely outside of large urban areas means more demand for dining out, entertainment, and other services in those areas, which in turn are having difficulties finding workers for those jobs.
- The pandemic also could have been the catalyst to lifestyle or behavioral shifts that necessitate economic reallocation and create worker/job skills mismatches. Retail goods spending further shifting toward non-store (mainly online) outlets is one clear example.
- Finally, slower population growth due to fewer births per death could slow labor supply growth absent a pickup in immigration.
While the ultimate magnitude of the impact of each of these issues is highly uncertain (as are the improvements in maximum employment that are achievable through directed policy), we think the gap between actual and maximum employment is currently around 6.5 million. According to our forecasts, this figure could decline closer to a range of 2 million to 2.5 million by year-end, reducing the unemployment rate to an estimated 4.5%. Relative to January 2021, this represents about a 70% improvement in the employment situation, which, in our view, is a reasonable interpretation of substantial further progress.
The ‘what’ and the ‘how’
Details about what the tapering plan will look like – including the pace and timing for diminishing and ending purchases of U.S. Treasuries versus mortgage-backed securities (MBS) – should become clearer in the weeks and months ahead, potentially when the July meeting minutes are released. We expect the Fed to announce a roughly proportional reduction in the monthly pace of purchases of Treasuries and MBS, and for the monthly purchase pace step-downs to continue for around three quarters. While Fed policymakers will likely craft guidance to give themselves maximum flexibility to react to evolving economic conditions, we think the most likely scenario is a relatively smooth reduction in the pace, similar to the way the Fed wound down its portfolio starting in 2017. (For more details on our expectations for tapering, read our recent Viewpoint, “Fed’s Latest Shift Still Consistent With Policy Framework.”)
Turning to the last question of how the Fed plans to minimize market volatility around tapering, Chair Powell has stated the FOMC intends to communicate “well in advance” of the actual tapering announcement. The July FOMC statement changes stopped short of “advance notice.” However, we believe the statement did set the stage for advance notice to be given in September for a December tapering announcement. Nevertheless, because the FOMC has provided little additional information on when and how they will provide this notice, this is admittedly uncertain.
In any case, we hope to get more information on these and other issues over the next few months, as the FOMC prepares markets for the inevitable first step toward policy normalization.
Visit PIMCO’s inflation page for further insights into the inflation outlook and investment implications.
Tiffany Wilding is an economist focused on North America and a regular contributor to the PIMCO Blog.
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