English (India)

The Fed may start QQE-4 tapering by early 2022

calendar 19/09/2020 - 17:50 UTC

In various previous Fed meets, Powell often referred to the longer-term dot-plots that have no material value and always stressed on near/mid-term economic circumstances and projections thereof. Although this time Powell did not trash the longer term (2023) dot-plots directly, he repeatedly stressed that the Fed has no particular number as an unemployment target (like 4%); it will target maximum employment and price stability (now around 2% average for a period of time). Thus Powell left the options open to shifting Fed goalposts as per evolving economic and political situation (post-Nov election) along with possible mass-vaccinations (COVID) by H1-2021.

Even if there is a COVID-19 vaccine by Dec’20, it will not restore the economy overnight. The full mass vaccinations will take at least H1-2021 for a single shot. And if there are two shots, 30/60 days apart, then it may take another 6-months. Thus we may have full/partial herd immunity against COVID-19 by natural infection as-well-as vaccination by the end of 2021. So, the actual sustainable economic recovery would start from 2022, and in that scenario, the Fed may prepare the market for an eventual QE-4 tapering by 2022 and the process of gradual hikes from 2023 (starting by one hike a year).

The Fed may be also concerned about higher inflation because of the thrust in ‘Made in America’ policy. The overall price stability (lower or almost nil inflation) in the U.S. may be the function of cheap import from Asia (China, South Korea, Japan) and South America (Mexico) coupled with relatively strong currency (USD).

But post-COVID, the USD is getting weaker against the Chinese Yuan (USDCNY tumbled from 7.20 to 6.75 since mid-May) due to various macro-economic factors. China is emerging stronger than the U.S. post-COVID-19. Weaker USDCNY along with additional Trump tariffs will cause more imported inflation for the Chinese consumer as-well-as industrial items. And, if the U.S. really starts to produce those Asian or South American goods itself rather than importing, the cost will further escalate because of higher labor, the raw material (overall higher production costs).

Thus the Fed may be also preparing itself for the higher inflation in the coming years and changed the target to average +2% core PCE, meaning it will not go for any hike even if it hits +2.25% to make up for previous under shootings.

 

 

The U.S. core PCE inflation average was around +1.7% for the last 6-years (2014-19); it has touched Fed’s target of 2% only three occasions during late 2018 to early 2019, although the core CPI is consistently averaged around +2.2%. The composition and calculation method of core PCE and core CPI basket is different and there is an average higher spread of +0.50 to +0.70% in favor of core CPI.

The core PCE (personal consumption expenditure) inflation measures the prices paid by consumers for goods and services, while core CPI measures the change in the out-of-pocket expenditures of all urban households (both excluding volatile energy and food). The composition and calculation method of core PCE inflation is designed in a way, that it would be very difficult to reach it even 2% most of the time, providing Fed, the space for price stability and accommodative monetary policy almost perpetually.

The U.S. core CPI was around +14% the early 1980s and after the start of Chinese/Asian exports, it rapidly fell to around 5% during the 1990s and then around 2% in 2000-2020s. Thus the so-called price stability is the byproduct of Asian and South American exports (cheap labor and currency) rather than the Fed’s monetary policy.

Now, if the U.S. core PCE inflation really hits +2.25% by 2023-24, the core CPI then may also hit almost +3.00%. As the average core PCE was around +1.7% in the last 6-years (2014-19), the Fed may allow it to run hotter to make it average +2.00% by 2025. For that, the core PCE needs to run around +2.25% on an average for 2020-26 and it will be possible only if the USD depreciates significantly against other major G20 currencies including CNY, EUR, and Yen coupled with ‘Made in America’ policy.

The market was expecting that Fed’s official Aug projections will show the core PCE inflation target at +2.25% in 2023, but that was not the case; it shows the usual +2.00% target. Thus, the Fed’s stance may be less dovish than expected.

But the Fed/Powell has left the options quite open by not defining any specific formula for average +2.00% core PCE and unemployment target. The Sep Fed monetary policy meeting was the last before the Nov U.S. election. The next policy meeting will be on 5th Nov, just days after the 3rd Nov election date. As the election outcome may be very close, there will be political uncertainty for the White House and Capitol Hill. We may have to wait for early Dec to know the actual winner between Trump and Biden (after Electoral College votes).

Thus, Powell (Fed) played it safe, kept options quite open, waiting for the next White House rhetoric. In any way, the Fed may be on hold until 2023 citing inflation and employment undershoot. But the question is whether the next President (Trump or Biden) will allow the Fed to hike in the next election year (2024). In that case, the Fed may have to wait for 2025 for its first lift-off (post-COVID-19) or began that early from 2022-23 itself (after COVID vaccinations), saying that it’s now confident that the inflation and maximum employment is going for the target. After all, the Fed has to prepare itself for the next financial crisis, most probably around 2030-32 (10-12 years cycle).

Bottom line:

The Fed may start its QQE-4 tapering by early 2022 and may also start a gradual hike (once a year) from 2022-23 after mass vaccinations for COVID-19 in order to prepare for the next financial crisis. Although Powell mentioned the ‘powerful’ forward guidance almost 15-times in his Wednesday speech and Q&A session (like BOJ’s Kuroda), Powell also mentioned ‘lift-off’ twice for the first time after March’20 (COVID-19). This shows that, unlike the last few meetings, the Fed is now thinking about gradual normalization going forward as the Fed can’t go into NIRP or YCC like the BOJ for the Japanification (deflationary) of the U.S. economy. Trumponomics or even Fedonomics is about reflation or at least Goldilocks' economy.

 

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