QE Magic, Used Cars, and Omicron: Tapering While Preserving Optionality

By Skanda Amarnath and Alex Williams

Throughout the pandemic, San Francisco Federal Reserve Bank President Mary Daly has been relatively dovish as a member of the Federal Open Market Committee. That is, until last week, when in an interview ahead of the Thanksgiving long weekend she commented that, “if things continue to do what they've been doing, then I would completely support an accelerated pace of tapering.” Chair Powell has signaled there will be active consideration of an accelerated “tapering” schedule in his answers to questions at his most recent Congressional hearing today.

When you pair the hawkish reaction function with the fact that real-time data suggests used car prices are still running hot in November and other dynamics supporting elevated near-term inflation prints, the rational implication is that rate hikes might come sooner and faster than previously expected. Insofar as elevated inflation represents things “continu[ing] to do what they’ve been doing,” a significant part of that cake is already baked, at least with respect to used car prices.

As is clear above, private measures of used car prices lead CPI measures of used car prices by three to four months. Those private measures are indicating further price acceleration into the end of the year, which will feed through to measured inflation. Since used car prices have helped drive inflation readings all year, it’s likely that inflation prints will remain hot through the end of the year.

However, the policy mistake worth worrying about isn’t the speed of taper per se - whether the pace of purchases declines by $10B/month or $20B - but the signal that taper sends about the timing of liftoff in interest rate policy.  

Since the Treasury market escaped its period of illiquid distress in March 2020, the Fed’s purchases of US Treasury securities have been a bit of a magic trick. US Treasuries and reserves (settlement balances) are roughly equivalent risk-free assets. Despite the Fed’s claims that each Treasury purchase is adding accommodation, it is hard to see how the purchase matters at all, unless contextualized in terms of its effect on the timing of interest rate hikes.

Because Fed officials continue to state that asset purchases necessarily add accommodation, the Fed and market participants collectively understand that rate hikes and asset purchases will not occur simultaneously. Of course, this understanding is built entirely on an illusion about the effects of asset purchases that Fed communication continues to prop up.

The most important information contained within the timeline for taper is about when to (potentially) expect future rate hikes, not when highly liquid securities will lose an incremental source of liquidity. Since the term structure of interest rates are highly sensitive to the expected path of short-term interest rates, information about the timing of rate hikes moves markets far beyond those directly affected by Fed asset purchases.

As the discovery and publicization of the Omicron Variant over Thanksgiving weekend underlines, the economy is still grappling with substantial uncertainty due to the ongoing health crisis. In the face of this uncertainty, the Fed should be judicious about how it preserves optionality and policy space. Fueling hype about rate hikes amidst a deteriorating recovery would likely damage labor market and investment conditions alike.

Outright curtailment of asset purchases in March would have the same net effect on the plausible rate hike timeline as President Daly’s suggested December announcement for taper acceleration. However, this approach would preserve greater optionality for the Fed should the economic outlook sharply deteriorate. Commodity prices are volatile, but they are signaling that the variant could substantially undercut global demand, at least for now. Hawkish comments on the timing of taper risk giving away the Fed’s downside optionality at a time when uncertainty still remains elevated.

As we move past the holiday season and get more information about the full effects of the most recent variant, the Fed will be in a better position to signal what they view to be the expected path of interest rates. To the extent that the outright termination of new purchases seems abrupt, publicly flagging the potential for early termination would provide sufficient notice.

The next few months will prove to be the most difficult for the Fed, as elevated inflation readings likely continue through the end of the year. Commentators and policymakers have already had difficulty interpreting the policy impact of the Fed’s new framework and Flexible Average Inflation Targeting regime. Comments like President Daly’s worsen the ambiguity and increase the risk of premature and punitive rate hikes.