MNI: Fed Challenged to Divorce Taper From Rate Hikes--Ex-Staff

Federal Reserve officials may have trouble convincing financial markets that a looming start to its tapering of bond purchases will not be swiftly followed by an interest rate increase, former Fed staffers told MNI.

Relief that the Fed may have avoided a 'taper tantrum' may be premature, the economists and researchers said.

"The Fed can say they're going to stop supplying these billions in purchases but that doesn't mean we're going to raise interest rates -- but the market might raise interest rates, and what are they going to do then?" William Gavin, a former vice president and economist at the St. Louis Fed, said in an interview. "The Fed cannot separate those. It cannot predict what will happen."

Gavin worries persistently low interest rates have had the perverse effect of retarding growth rather than boosting it by weakening business and consumer expectations of future economic prospects. By that logic, a tightening of policy could actually fuel optimism about the recovery and expectations of higher rates.

FED DIFFERENTIATES TAPER FROM HIKES

Top policymakers including Fed Chair Jerome Powell have gone to great lengths to try to divorce the tapering process from interest rate hikes, including setting a much higher bar for the latter.

Yet a recent spike in Treasury yields following a more hawkish Summary of Economic Projections in September suggests investors have muddied views on the Fed's reaction function. The SEP also points to a clear split among officials themselves over how high interest rates will ultimately go. Imminent personnel shifts could also shift the balance of views within the Federal Open Market Committee.

"It's very unclear to me the connection between tapering and interest rates," Rick Roberts, a former staffer at the New York and Kansas City Feds who now teaches at Monmouth University, told MNI

"Powell seems to want to disentangle these, but I do not at all think the Fed has done a good job of explaining, in large part because I don't think they understand it well. What has QE done for us and what will removing it or at least slowing the pace of asset purchases do to us? The lack of clarity on those fronts increases the risk of market turmoil."

BREAKING UP IS HARD TO DO

The one thing Fed officials have made explicit is that they would like to complete the tapering before hiking rates. But that, Roberts and others said, has the effect of making investors price in rate hikes more aggressively as the Fed signals a shorter-than-expected taper ending in mid-2022.

"If QE was good news and gave us a boost up front, one might expect that a slowing of that would be some somber news that would put some pressure on the economy. But no one talks about that," Roberts said.

"All I can say with certainty is that tapering is a necessary step to get to an ultimate Fed liftoff. We have to get to step A before we get to step B. Why that is I don't know, I'm not sure the Fed even understands it."

Official growth forecasts have already been trending lower. The Atlanta Fed 's GDP tracker is pointing to a Q3 expansion of just 1.3%. At the same time, 10-year yields have been on the rise, spiking 30 basis points in just two months to around 1.5%.

"In their own minds they have separated those things," said Stephen Cecchetti, former research director at the New York Fed and now a professor at Brandeis University, pointing to how officials have established distinct criteria for tapering, which requires only "substantial progress" toward inflation and employment goals, and actual rate hikes, which would need the actual achievement of price stability and full employment.

"The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test," Powell said at his September press conference.

Yet because these criteria have been nebulously defined under the Fed's new framework, there's a lot of room for error and miscommunication.

"I do think it's sensible to think of asset purchases during normal market times as commitment devices to keep rates lower for longer. And if that's the case, then the only way they can raise rates is they stop that commitment. So the sooner I stop that commitment the sooner I can raise rates."