Fed is watching how BOE inches to a taper

“Some modest tightening of monetary policy over the forecast period is likely to be necessary” was how the Bank of England worded the forward guidance at its quarterly review on Thursday. It sounded like tough talk. Indeed, the BOE is the first of the major central banks to set out a template for reducing stimulus, with parameters for when the flow of quantitative easing will stop, when the balance sheet will be allowed to naturally taper — and even when it will be actively sold down. But, in reality, the BOE is playing for time. What Governor Andrew Bailey has done is set out his shop stall for others to peruse. The others being fellow central bank chiefs preparing for their annual conference at Jackson Hole, Wyoming from August 26 to 28. They are just as focused as Bailey on how markets and economies will respond when they finally have to roll back their own stimulus programs.
Among them is Fed Chair Jay Powell, who has one eye carefully focused on his own reappointment for a second term, a decision that is due from the Biden administration in the fall.
With US consumer inflation running at a 5.4% annual pace, there has to be a Fed contingency plan if the economy continues to run super-hot. A near-1 million job gain in July non-farm payrolls, shows recovery momentum is still impressive. It seems a touch crazy then that the Fed is still adding $120 billion monthly (a third in mortgage-backed bonds) to a balance sheet in excess of $8 trillion, especially as US house prices (and perhaps even more significantly rents) are rising at the fastest pace in over 30 years.
With the European Central Bank and the Bank of Japan lagging in the rear-view mirror, it is incumbent on the Fed and BOE to run reconnaissance on how and when it is prudent to reverse stimulus. Unfortunately, the Fed still has nightmares about the May 2013 Taper Tantrum that caused a credit crunch and saw a lot of hard work unwound.
Yet persist they must as a loss of inflation-fighting credibility is a risk no central bank can toy with. Despite recent comments from Powell focusing on the still-high levels of underemployment, the Fed really can’t wait until all the pandemic economic effects are nullified. Employment is a lagging indicator, and by the time it returns to pre-pandemic levels, you won’t be able to push the inflation genie back in the bottle.
Realistically, no one wants to tinker with liquidity in the system (code for maintaining the stock as well as the flow of QE) until after a mini-rate hike is tried out. From there it’s all in the sequencing between when interest rates rise and when QE is gently rolled back. It needs to be a harmonious blend. The BOE’s balance sheet of 895 billion pounds ($1.2 trillion) is the equivalent of 40% of gross domestic product and proportionally the largest of the big four central banks. A quarter of its holdings will mature between now and end-2025 but all these (and coupons) will continue to be fully reinvested until the official bank rate of 0.1% is lifted to 0.5%, according to the new guidance. Yet the money markets are not pricing for any rate hike for at least a year and not until 2028 to half a percent, so it maybe several years before the balance sheet is meaningfully reduced, as Bailey suggested last year. It is quite the disconnect between hawkish rhetoric and dovish reality.

—Bloomberg