Observing the market reaction to various economic releases and comments by Federal Reserve members since the end of the first quarter, it’s clear that the next catalyst for rates hinges on the Fed’s timing of asset-purchase tapering.
The Fed continues to be patient in communicating—or even discussing—its plans for tapering, with the rationale that such conversations could lead investors to aggressively reprice monetary policy expectations.
The dual criteria for policy adjustment remain:
- PCE inflation above 2% for some time
- The labor market’s achieving “maximum employment”
However, the Fed has shifted focus to its newly constructed aggregate inflation expectations measure, the “Common Inflation Expectations Index,” to provide the guidepost for inflation criteria. Under the theory that inflation expectations have historically shifted higher mostly due to persistence in actual inflation, the key implication is that more time would be required before a Fed rate change. With this understanding, we think the Fed has deftly separated the tapering decision from the policy rate liftoff decision: A higher aggregate inflation expectation will be required for rates liftoff, while “substantial progress” that puts the labor sector on track to “maximum employment” will be needed to trigger the tapering decision.
Though highly uncertain, we define the FOMC’s “maximum employment” target as equivalent to an unemployment rate between 3.5% and 4.0% and a pre-pandemic level of labor force participation of 63.3%. As such, we estimate that an average monthly payroll figure of approximately 400,000 over the next 25 months through June 2023 (around the Fed-dots-implied timing for rates liftoff) should qualify as “substantial progress.”
We think this is achievable due to the strength in labor demand indicators as well as our analysis of trends within key sectors, such as leisure and hospitality, that have lost substantial employment in the pandemic period.
It is our belief that two consecutive solid payroll reports, added to a recent, subtle shift in communication by Fed members and Wednesday’s announcement to wind down the SMCCF (Corporates) program, will lead the Fed to begin its tapering conversation. Should that happen, lots of uncertainty around implementation will remain, including the distribution between mortgage-backed securities and U.S. Treasuries, as well as scheduling, among other issues.
Overall, we believe that a potential start of the tapering conversation could result in greater market volatility in the second half of the year, as investors grabble with this transition.
For an update on the European Central Bank and our expectations for the coming meeting, take a look at my colleague Patrick Barbe’s latest NB Blog