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Taper tantrum fears: Fed chair has to be careful not to unleash market chaos

Tapering, of course, doesn’t stop the Fed adding monetary stimulus to the US economy and global financial system but only reduces the quantum of that stimulus.

Nevertheless, as we saw in 2013 when the Fed first outlined its plans to reduce the rate of the asset purchase’s it had been making in response to the global financial crisis, investors can panic if they think the safety nets under the markets are going to be withdrawn.

During the “taper tantrum” in 2013 bond yields as bond prices crashed (they have an inverse relationship) and equity markets slumped more than four per cent in three days after then-chairman Ben Bernanke raised the prospect of tapering the QE program. The Fed backed off, continuing its purchases until late 2014.

Markets will be glued to what Jerome Powell has to say this week.

Markets will be glued to what Jerome Powell has to say this week.Credit:AP

Mindful of that episode, Powell has made it clear that the Fed will give the markets plenty of warning and clear timelines for reductions in the rate of asset purchases to try to avoid the kind of shocks experienced in 2013.

Given that Fed chairman have historically used the Jackson Hole conference to discuss prospective policy changes – Powell used last year’s conference to unveil the detail of a shift from targeting prospective inflation to one that responds after inflation has already exceeded its two per cent target – there is an expectation that, at the least, he will outline the pre-conditions for the start of the winding down of the Fed’s asset purchases.

There’s a lot of debate, within the Fed and outside it, about what the appropriate monetary policy settings should be within an environment riddled with uncertainties.

Inflation rates have spiked and remained stubbornly high. The Fed has tended to refer to the burst of inflation as “transitory,” driven by the impact of the pandemic on supply chains and consumer behaviours.

The persistence of the supply chain disruptions and the Biden administration’s planned dramatic increase in government spending mean, however, that the transition could be a lengthy one and lock in an inflation rate at levels that would eventually force the Fed’s hand.

During what was a very strong recent quarterly reporting season a consistent theme from US company executives was that they were experiencing higher prices for their inputs that they planned to offset via higher prices for their products, which would tend to entrench inflation at higher rates.

While US employment data and economic growth more broadly have been strong, the outbreaks of the Delta mutation of COVID-19 have added considerable uncertainty to the US and global economic outlooks.

China’s recent weakening economic data, in particular, reflects a Delta-induced slowing of what had been a very big bounce from last year’s lows and, with a wave of Delta now spreading rapidly throughout large parts of the US and elsewhere in the world, the prospect of an aborted global recovery has strengthened. That might give the Fed pause for further thought.

Powell would be acutely aware that any misstep in unveiling and detailing the Fed’s plans could cause chaos in the markets, adding wealth effects and fear to the raft of other threats to US, and global, economic growth and stability.

Should the Fed decide to proceed with tapering later this year it will create some difficult decisions for investors, with asset prices – particularly share and house prices – seemingly predicated on “QE forever.“

The US sharemarket, for instance, is up about 93 per cent from last year’s lows (it was closer to 95 per cent before last week’s sell-off) and the Australian market about 54 per cent.

Interestingly bond investors haven’t shared the continuing optimism of their equity counterparts.

After yields spiked to 1.75 per cent earlier this year they have fallen back to around 1.25 per cent in recent months and remained there despite the surge in inflation, with the investors apparently more focused on Delta and the prospect of another crushing of economic growth than sharemarket investors.

Over the past two months currency traders appear to be in sync with the bond market. The US dollar and the US Treasury bond market are the world’s traditional financial safe havens.

Meagre bond yields (solidly negative in real terms) and an appreciating US dollar – it’s strengthened more than four per cent against the basket of its major trading partners’ currencies since mid-June – are indicators of risk-aversion and a flight to safety, presumably sparked by the virulence of the Delta outbreaks and their implications for a return to something resembling a pre-pandemic normal.

The prospect of a sustained break-out of inflation, it seems, isn’t being priced into those markets.

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Powell and the Fed are poised to outline their plans for tapering, if not this week then next month, even as financial markets are very divided on the outlook for the economy and the course of the pandemic.

He’d be acutely aware that any misstep in unveiling and detailing the Fed’s plans could cause chaos in the markets, adding wealth effects and fear to the raft of other threats to US, and global, economic growth and stability.

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