From the minutes of the previous Federal Open Market Committee (FOMC) meeting and the discussions on July 28, it is clear that the US Federal Reserve has initiated the promised advance notice for tapering of quantitative easing (QE).
The formal statement retains that the Fed would wait some more till “further progress” on its objective set is attained before tapering its bond-buying programme of $120 billion per month. While the discomfort over inflation remaining substantially above 2 percent is growing, it is still seen as transient.
All said, in our assessment, there is a high possibility of tapering being initiated in November 2021. Indian equities have been sideways for the past two months, as foreign institutional investment (FII) flows have moderated and turned negative recently. Built-up of data flow towards tapering may continue to weigh on market sentiment.
Beyond the formal statement, substantive communication came from the question and answer session. Here is what we gathered:
The FOMC has started discussing the modality and pace of QE tapering in a serious manner. Several members have proposed QE tapering, and offered suggestions. Hence, it is not a matter of “if”, but the timing. The Fed has initiated the advance notice for tapering, in our view.
Inflation has been running substantially higher than the target of moderately above 2 percent. At the moment, inflationary pressures are seen coming from select components facing supply bottlenecks relative to strong demand rebound. However, if it endures, the Fed will be ready to adjust the policy stance.
How transitory is high inflation? The spike in prices may not come down but the pace will slow after some months (say 12 months), it may not translate into a spiral or an inflation process.
A rise in inflation because of rising wage costs and raw material costs is not counted as an inflation spiral. The Fed does not have a clear idea of the pace of decline in inflation, even as it considers the current spike as transitory. We see that as a good enough sign to initiate tapering.
Chairman Jerome Powell was more emphatic in denying the case of rate lift-off from zero level but was more patient in articulating what it will take to start the tapering process.
In particular, the Fed will look for more data, at least till September when the American Rescue Plan ends. More clarity will emerge on whether the current tightness in the labour market and wage spikes are persistent or not; how will workers respond once the dole out are gone?
At the moment there is a peculiar situation of 9.2 million job openings but 7 million are still seeking jobs. If the wage pressure sustains beyond September, the case for tapering will only get stronger.
The economic impact of new Covid-19 waves is seen to be softening as firms and households have learnt to adapt, as seen during the second wave and the pace of vaccination has been robust. New waves may prolong the case of people not coming back to jobs, leading to a lingering labour shortage.
The influence of multi-speed global recovery on policy decisions is less relevant in determining the Fed’s future path as a higher pace of immunisation has translated into a stronger rebound in the US and now also seen in Europe.
What is meant by substantial progress before tapering? The primary concern is the labour market, as 7 million are still seeking jobs—the Fed wants to see a good rise in employment. Powell thinks full employment will not take much time as the labour market is seen as being “very strong”.
Glimpses of how they are planning the taper: a number of FOMC members argued that the tapering should start with knocking off the $40 billion monthly purchase of MBS, especially in light of the house price bubble. Powell said there is little justification for starting out with MBS, as the economic impact of both treasury and MBS purchases is similar. So the tapering will happen with simultaneous reduction in purchases of both MBS and treasury. The speed of MBS tapering may be faster.
In our view, the idea that prices will not come down and it will be the base effect that will eventually bring down inflation is an indication that inflation may remain higher than 2 percent till the end of March 2022.
Wage inflation and a tight labour market amid abundant job availability are indeed abnormal in the context of extant unemployment. Since the Fed does not have any idea of the pace of decline in inflation in the near future, it wants to examine the labour market situation after the American Rescue Plan ends in September 2021.
If wage inflation remains high, and core inflation remains elevated, the case for tapering will get stronger.
The gambit is that once the dole ends, labour availability will improve and match up with the prevailing abundant demand. But chances are that wage pressure may not subside even then. Thus, prompting tapering in November 2021.
The US bond curve continued to flatten after the statement, with 10-year declining modestly to 1.23 percent (1.26 percent previous), and 30-year declined to 1.88 percent from 1.92, However, the dollar weakened a tad (DXY at 92.27, down 0.17 percent) as the Fed failed to announce a tapering timeline. But we think that continued flattening of the UST curve sustains the hypothesis of tapering, and the Fed eventually responding to higher inflation.
From our India portfolio standpoint, FII flows have been fairly modest over the past three months, with outflows seen during July. This may continue to weigh on market sentiment in the coming months.
Considering a score of global inflections with respect to the Fed’s tapering and US fiscal cliff, rising probability of US-China conflict, fading of China fiscal stimulus in 2H2021 and after, and ebbing of the unsustainable commodity bubble, we have aligned our portfolio pre-emptively (India strategy, 1 July 2021) towards a more defensive construct. We maintain the same positioning.
(The author is Managing Director & Chief – Strategist, JM Financial Institutional Securities)Disclaimer: The views and investment tips expressed by experts on moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.