MNI: Faster Fed Taper Possible, Rate Hike Room Limited

The Federal Reserve could consider speeding up its tapering of bond purchases if inflation continues at a rapid pace, but the order of its exit plans may prevent rate rises from moving much earlier into 2022, former Federal Reserve staffers told MNI.

While the base case remains for inflation to fall in 2022 towards the central bank's 2% target, consistent with a taper anticipated to run from late this year until June or July, the ex-staffers said there are heightened risks inflation could remain high.

"If they don't move by next spring or summer it will reinforce a sense among many consumers and businesspeople and financial market participants that the central bank doesn't really care that much about inflation that could reinforce the momentum toward inflation remaining high or even going up further," said Andrew Levin, a former Fed Board economist who served as a special adviser to ex-chair Janet Yellen.

Levin, now a professor at Dartmouth College, saw scope for the Fed to ramp up its taper next year. "What certainly seems plausible is if they get to January and they really think they probably will have to lift off next year then they'll finish the taper in March or April, suspend the reimbursements in June, and they'll start rate hikes a few months after that," he said.

ORDER OF OPERATIONS

But the Fed has signalled that rate hikes will only come once more stringent price stability and full employment goals are achieved, and only following the taper

Ellen Meade, a former senior adviser from the Fed Board's monetary affairs division, said persistently higher prices can only push the Fed so far.

"If you end the taper in June, then at the July meeting discuss liftoff, and use Jackson Hole to signal rate hikes, then you could hike as early as September," said Meade, who nonetheless sees rate hikes in December 2022 as the base case.

"There may be some scope to initiate an earlier discussion of changing the pace of the taper," she said. But "unless the economic situation and inflation expectations are really out of control, you wouldn't adjust that taper flow."

The Fed is expected to announce next month that it will begin reducing its USD120 billion in monthly bond purchases by USD15 billion per month starting in either mid-November or mid-December. Market pricing now implies a first rate increase coming in September 2022, followed by at least one more 25-basis-point move before the end of the year, according to the CME's FedWatch tracker.

PROCESS AND POLICY

Fed officials in recent weeks have struck a more hawkish tone and some have suggested greater tension next year between the employment and price components of the central bank's dual mandate. This week Fed Governor Christopher Waller showed openness toward bringing forward rate hikes should inflation remain high.

Michael Bordo, a former Federal Reserve and Bank of England researcher, said a policy response should not be constrained by normalization processes. "Letting the process overtake what's happening on the ground with respect to inflationary pressures that are building up will lead to a big problem," he said.

Still, others say the Fed will wait until 2023, and not over-react to supply-side constraints that are outside the central bank's remit. "Monetary policy cannot affect the inflationary pressures due to supply chain disruptions or the energy crisis. That's why the Fed is hesitant about a premature rate hike," said Selva Demiralp, a former economist at the Fed Board. "If expectations start to diverge from the target, however, the Fed might need to act sooner with a rate hike."