Morgan Stanley: The FOMC Has Begun To Envision How It Will Taper QE

In our preview of today’s FOMC minutes, we said that the most important question was whether there would be any mention or disclosure on whether the Fed’s QE would be tapered, or alternatively, if the Fed would boost its QE. And while there was a tangential discussion of this (the word taper was used exactly once in the FOMC Minutes), as “a number of participants noted that… a gradual tapering of purchases could begin and the process thereafter could generally follow a sequence similar to the one implemented during the large-scale purchase program in 2013 and 2014”, there was no firm commitment either way since the Fed was far more concerned by the recent surge in covid cases across the US, and the impact this would have on the economy.

That said, in the context of the blue sweep which saw Chuck Schumer today promise that $2,000 stimulus checks are just a matter of time, it is far more likely that sooner rather than later the Fed will have no choice but to start contemplating how it will tighten as BofA suggested earlier today:

Time to start pricing in rate hikes:

BofA: “the Fed will remain as easy as possible for as long as possible, but at some point the market will expect that countercyclical monetary policy orthodoxy will kick in and the Fed will have to move”

— zerohedge (@zerohedge) January 6, 2021

In her post-mortem to the Fed minutes, Morgan Stanley chief economist Ellen Zentener agreed writing that “the minutes of the FOMC’s December meeting showed policymakers taking on a more optimistic tone about the medium-term outlook for growth and inflation. Policymakers favored a status quo policy for now, but have begun to envision when and why they may begin to taper asset purchases.”

Her full note below:

The minutes of the December FOMC meeting showed policymakers becoming increasingly confident in the medium-term economic outlook. Participants discussed the “resilience” of the economy, a “stronger than anticipated” recovery, and indications of potentially “greater momentum in economic activity than had been previously thought”. The tone of that discussion was broadly consistent with the changes to the economic forecasts in the Fed’s Summary of Economic Projections (SEP) at that meeting, where policymakers upgraded their growth forecasts, although it remained notable how policymakers discussed expectations of potentially slowing in the expansion over the winter while still holding the view that “positive vaccine news received over the intermeeting period was…favorable for the medium-term economic outlook”, suggesting the Fed would likely not overreact to near-term softening in the data.

Policymakers even sounded somewhat more optimistic on inflation, with only “a couple of participants” raising concerns about potential longer-term downward pressure on inflation, while others noted that soft price pressure may dissipate post-vaccine, and the recent pickup in market-based measures of inflation compensation added to confidence in the medium-term inflation trajectory. That was also reflected in some upward revisions to inflation forecasts in the December SEP, as well as in participants viewing the risks to the inflation outlook as becoming more balanced.

On policy actions, there was strong support for maintaining the status quo on balance sheet policy. All participants supported maintaining the current pace of purchases, and “nearly all” favored maintaining the composition, with only “a couple” favoring extending WAM in December.

All participants also supported the guidance that the Committee would maintain the current asset purchase program until there had been “substantial further progress” toward the FOMC’s goals, although in their discussions of what “substantial further progress” toward their goals might look like, participants generally noted that the judgement would be based on broad, qualitative criteria and not on specific numerical criteria. That leaves a lot of scope for discretion, and so participants in their discussions put an emphasis on the need for clear communication. We have believed that Powell would likely give a long heads up as the FOMC moved toward discussing the end of the asset purchase program.

And here is the punchline:

We forecast that stimulative fiscal action and vaccine distribution will propel GDP growth by 6.0% 4Q/4Q this year, well above consensus and Fed estimates. On our forecast, the Fed will need deliberate the appropriate timing for taking its foot off the gas pedal and we expect Chair Powell could unveil these discussions as early as the June FOMC meeting. We continue to see the Fed announcing a taper at its December 2021 meeting, to begin in January 2022.

The minutes also noted that the exit from the asset purchase program may look like the 2013-14 exit from QE3. We read that to mean the Fed plans to taper its asset purchases gradually, much like they did previously, and we see the FOMC tapering its asset purchases beginning in January 2022 at a pace of $10bn/month in Treasuries and $5bn/month in MBS.

More recent comments from policymakers suggest that discussions about the eventual exit from the asset purchase program may continue to ramp up into the middle of this year as well. This week, Atlanta Fed President Bostic expressed his optimism that if the economy “strengthens appreciably” then the FOMC can “start to recalibrate” in “fairly short order”, implying tapering could begin as early as this year. Though the minutes did not indicate that this is a consensus view among the Committee, and indeed others (e.g. Mester) have contradicted this view more recently, Bostic’s comments underscore the challenges the Fed could face in deciding its next course of action.

As a reminder, the last time the Fed tried to taper without sparking a market crash was in 2013… and the result was a disaster with bond yields pulling back by 150bps in a few weeks. This time, with the Fed’s balance sheet nearly 3x bigger, even the faintest attempt to tapering QE from its current pace of $120BN per month would have devastating consequences for all assets, which is why we don’t share Zentener’s optimism that the Fed will rush to discuss tapering as early as June.