Perhaps time is passing particularly slowly during the pandemic because, when I think back to the Fed’s taper tantrum in 2013, it feels like a lifetime ago.
Back then, the U.S. economy had broadly recovered from the global financial crisis when then-Fed chief Ben Bernanke and other Federal Reserve officials began to subtly disclose their intentions to wind down the quantitative easing (QE) program. Although the tapering of the massive monetary stimulus did not actually occur until the end of that year, those comments were enough to trigger a nerve in the market. U.S. Treasury yields shot up in response, and at the same time, there was evidence of an outflow of capital from Asia, South America and other regions, causing their stock markets to adjust downward and their exchange rates to depreciate.
Having experienced this thrill in the past, with the U.S. economy now back on track, the market is inevitably speculating when tapering will occur this time. Many local media have described the Fed’s current stance as “expecting to hold rates near zero at least through 2023.” This statement is actually very misleading because one of the major premises of the Fed’s forward-looking approach to not raising interest rates is that inflation has been performing well, remaining roughly within the 2% target, or marginally over the target.
Public opinion polls, Treasury inflation-protected securities (TIPS), option premiums and other indicators, as well as the Federal Reserve’s internal analysis, all suggest that long-term inflation expectations will not change significantly. Moreover, inflation will indeed move higher in the near term but the rate of increase will be limited with little chance of a significant jump.
There is nothing to worry about inflation getting out of control but rather an awkward situation where it is only a little higher than expected, not too high, not too low, for example, between 2.5% and 3%. This is definitely not a once-in-a-blue-moon event, such as super inflation, and there is a good chance that it will happen within this year. The awkwardness lies in the fact that the Fed will inevitably have to face the reality and can no longer be vague. The Fed will have to state clearly the tapering conditions and explain what constitutes excessive inflation and how long it can be sustained. The more awkward the Fed is, the more imaginative investor expectations become, and the taper tantrum will be even more intense and dramatic than it was back then.
(Tsang Kwok-Ping, Associate Professor in the Department of Economics of Virginia Polytechnic Institute and State University)
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