Looking at the FED Objectively on Whether It’s Going to Taper
You would have heard about the FED “tapering” or reducing their bond-buying programs/increase interest rates these days. The FED’s action would have consequences for the world. Read more below on what I think the FED is going to do!
I have previously written about the impact of the FED on regular people on the street through the effects of exchange rates and investments. There has been a lot of news recently about the “tapering” of the FED or in layman’s terms, reducing interest rates for the economy. Some have speculated that the US might actually increase interest rates and reduce its bond-buying programs, as inflation is high and the economy is recovering. On another hand, some people have said that it’s too early to increase interest rates considering the economy has not fully recovered. Who is right? Who is wrong? I will attempt to provide my 2 cents on what the FED is considering in its policies and how it will impact the markets around the world.
First of, the FED is worried about whether the economy is recovering sufficiently first, and then whether inflation is high.
Contrary to popular beliefs, the FED actually cares more about the state of the economy and whether Americans are doing well. As cliche as it sounds, this is true. Let me elaborate.
The FED’s role in the economy can be summed up best as ensuring prices are stable and that employment is maximised. Prices are stable when it is at about 2%, and employment is maximised when the unemployment rate is at 4.1%. However, the FED has proven to be more concerned about the unemployment rate or output gap (explained later) in the past in ensuring that the economy is churning along. Time for some history lessons regarding this.
Back in the 1970s and some portion of the early 1980s, the United States underwent what people termed “stagflation” where inflation was high and economic growth was low. This meant that people’s wages were not growing that much but prices of everyday items were increasing at a high rate. Volcker was appointed as the FED’s chairman in the 1980s, where he explicitly said that he will bring inflation down no matter the cost. He hiked up interest rates so high that it actually caused a recession in the meantime. However, the result of that policy was actually bringing down the inflation rate for decades after that. From the late 1980s until now, inflation has never again registered anything above 6%.
Hence, the FED after Volcker in my opinion focused more on the output gap or how the economy is doing, rather than inflation. Volcker was unpopular at the time when he plunged the economy into a recession but he was also responsible for ensuring low inflation after that and the biggest economic expansion for the United States. Bernanke who was the former FED chairman posited that the FED targeted the output gap more than the inflation rate. In the past 5 years, inflation rate averaged only 1.5%
In my experience, the FOMC paid closer attention to variants of the Taylor rule that include the higher output gap coefficient. For example, Janet Yellen has suggested that the FOMC’s “balanced approach” in responding to inflation and unemployment is more consistent with a coefficient on the output gap of 1.0, rather than 0.5. In my modified Taylor rule I assumed the higher coefficient on the output gap.
Inflation is relatively high at the moment, but attention should be channeled instead to how the economy is doing.
Inflation rate has been projected at 4.8% for 2021, the highest it has ever been since 1990. This is way above the 2.0% inflation target set by the FED in its mandate. However, this needs to be interpreted by the context of inflation being historically low in the 2010s due to the 2008 recession impact. In the past 5 years, inflation only averaged about 1.5% every year, way below the 2.0% inflation target. The fact is that the United States was having problems, HAVING inflation in the economy before this. The steep increase in inflation this year should be balanced by this fact and that the Covid-19 recession depressed prices also.
How is the US economy doing then? It is recovering gradually and has surpassed 2019 levels in GDP, but they still have some catching up to do. GDP in 2Q 2021 is at $19.4 trillion, above the level of 2Q 2019 of RM18.9trln. This translates to an average growth rate of 1.3% every year. Before that, from 2015 to 2019, GDP growth averaged around 2.4% every year. While the US economy is recovering, it has shown that it is not yet growing at pre-pandemic levels.
Unemployment rate at 4.8% currently also has recovered significantly but has not reached that 4.1% target or the 3.5% before the pandemic. With the FED giving much more emphasis on the recovery of the economy, it probably does focus on inflation but not as much as the economy.
The FED will continually focus on the unemployment rate and economic growth but could reduce interest rates if the US economy recovers rapidly.
The unemployment rate is approaching the 4.1% targeted by the FED in its mandate so if the unemployment rate reaches that level, the FED might consider reducing interest rates. However, it could be the case that the FED might try to drive the unemployment rate further down to below 4.0% as they do not want to risk jeopardizing the economic recovery. The part on inflation will depend on whether price inflation will continue to rise but that does not seem the case as August inflation rate decreased slightly to 5.3% compared to its peak of 5.4% in July 2021. Even if the FED decides to tighten, it needs to consider that inflation historically has been low at below inflation target. It can instead target average inflation instead of 2.0% rather than current inflation rate.