Fed minutes a warning to investors over QE

Speculation that the US Federal Reserve will react to signs of economic growth and inflation by lessening its asset purchases may come back to haunt financial markets.

Jerome Powell, chairman of the U.S. Federal Reserve Picture: Bloomberg

Shares rebounded strongly after Wednesday’s sell-off, but speculation that the US Federal Reserve will react to signs of economic growth and inflation by lessening its asset purchases may come back to haunt financial markets which have benefited from unprecedented monetary policy stimulus.

In its fifth-biggest one-day rise this year, the S&P/ASX 200 rose 1.3 per cent to 7019.6 points.

To some extent the market rose strongly because it fell sharply the day before.

There was also a bullish report on the buy now pay later sector from Macquarie, including an upgrade to “outperform” on Afterpay, as well as an unexpected fall in the unemployment rate.

More importantly, the US sharemarket mostly recovered from jitters caused by massive falls in cryptocurrencies, and the Australian market had fallen 3.6 per cent from a record high.

Investors who were taking profits on winning bets and offsetting them against losses on losing bets for tax purposes before the financial year end may have also backed off after sharp falls this week.

Dips have been remarkably shallow in the past 12 months, mainly because of extreme monetary policy stimulus from central banks globally, and in particular the $US120bn ($155bn) per month of liquidity provided by the Fed under its asset purchase program, better known as quantitative easing or QE.

But while almost ignored by the market amid all the chaos in cryptos, the minutes of the Fed’s April 27-28 board meeting gave an important warning about nascent signs of inflation in the global economy and the implications for US monetary policy.

“A number of participants remarked that supply chain bottlenecks and input shortages may not be resolved quickly and, if so, these factors could put upward pressure on prices beyond this year,” the minutes said.

“They noted that in some industries, supply chain disruptions appeared to be more persistent than originally anticipated and reportedly had led to higher input costs.

“A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”

And “some participants mentioned upside risks around the inflation outlook that could arise if temporary factors influencing inflation turned out to be more persistent than expected”.

Most importantly, while they emphasised the lingering risks to the US economy from the pandemic, the minutes indicated that a tapering announcement could be made in the next few months.

“A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”

“In other words, there are a growing number of officials who think that tapering of quantitative easing is a policy option worth considering if economic growth stays strong,” said Credit Suisse Australia strategist Damien Boey.

Any lessening of QE announced by Federal Reserve chairman Jerome Powell could entice the Reserve Bank to lessen its own QE.

“In our view, given the Fed’s commitment to adjusting policy only when substantial progress is made on its job creation and inflation objectives, and its promise to providing investors with ample notice of tapering before it actually happens, this rhetoric seems quite significant,” Boey said.

“It certainly stretches the meaning of recent Fed comments that now is not the time to be talking about tapering. Rather, now seems to be the time to talk about talking about tapering. Perhaps we should now consider ourselves served with ample notice.”

Also, in the context of the Fed’s new “outcome-based guidance” — which sets policy based on “observed progress toward the committee’s goals, not on uncertain economic forecasts” — the minutes said “a couple of participants commented on the risks of inflation pressures building up to unwelcome levels before they become sufficiently evident to induce a policy reaction”.

It was a subtle warning that under the Fed’s new approach to monetary policy — also adopted by the RBA — there might be an outbreak of inflation that’s hard to stop without a sharp rise in rates. Financial markets are completely unprepared for that.

When the Fed last met in late April there were some signs of a slowdown in US jobs growth, core consumer price index inflation was a subdued 1.6 per cent and the Fed’s common inflation expectations index was 2 per cent — roughly in line with 2018 levels.

But since then, core CPI inflation has risen to 3 per cent, and the CIE looks to be running at 2.15 per cent, its highest level since 2008, according to Credit Suisse.

“Also, while employment growth is slowing relative to consensus expectations, it is still robust by historical standards,” Boey said. “Similarly, while retail sales stalled in April, real year-ended growth is running at over 40 per cent.

“Taking into account all of the new information since the Fed meeting one could stretch their interpretation of employment and consumption data to say that the activity threshold for beginning serious tapering discussions has not been crossed just yet.

“But the inflation data is working the other way to throw a cat among the doves.”

Of course most Fed officials continue to downplay inflation risks by insisting that the recent increase is “transitory”, but Ms Boey doubted growth would slow enough to widen the output gap.

“All indications are that such a slowdown is not underway yet,” he said.

Boey said a tapering discussion was likely and that the Fed would announce a plan to do so in 2022 — potentially around the time of the Jackson Hole summit in August.

“The Fed should feel comfortable that they have given the market a long runway,” said RBC chief economist Tom Porcelli.

“Though, unfortunately for them, we are still not sure the equity market will take it well.”